November 6, 2017 House tax reform bill has state tax implications The House tax reform bill introduced on November 2, 2017, and titled the "Tax Cuts and Jobs Act" (H.R. 1) (the House bill) introduced the most significant corporate and individual federal tax reform proposals in over 30 years. If enacted, the proposals will result in lower corporate and individual income tax rates with a trade-off of eliminating many federal tax credits and corporate and individual deductions. These changes would generally take effect for tax years beginning after December 31, 2017, unless otherwise noted. This Alert focuses on the US state and local (collectively, state) tax implications of the House bill. For more highlights of the bill, see Tax Alert 2017-1831. For a more detailed discussion of the bill's individual provisions, see Tax Alert 2017-1840. For a more detailed discussion of the bill's corporate and international provisions, see Tax Alert 2017-1845. For a more detailed discussion of the bill's business and individual provisions, see Tax Alert 2017-1847. As the legislative process swiftly moves along, it is widely anticipated that the Senate will soon introduce its own measures and that the House bill itself will be subject to amendments and modifications. Thus, the legislative situation is dynamic, and tax professionals are advised to carefully monitor the legislative developments in Washington as they progress. Summary of key tax reform provisions Key aspects of the House bill affecting businesses include: — Reducing the corporate income tax rate to 20% (from 35%) — the reduction would be permanent and would be set without a phase-in or phase-out (personal service corporations would be subject to a 25% tax rate) — Replacing the current US worldwide tax system with a territorial tax system that would exempt 100% of the foreign-source portion of dividends received by a US corporation from a foreign corporation in which the US corporation owns at least a 10% stake and would tax on a current basis potentially significant amounts of certain foreign income under anti-base erosion provisions and modifications to the Subpart F regime — Imposing a one-time 12% transition tax on certain previously untaxed accumulated foreign earnings (reduced to 5% for illiquid assets) through a new mandatory one-time Subpart F inclusion (the US shareholder could elect to pay the transition tax over eight years or less) — Imposing a new 20% federal excise tax on certain payments made by US domestic corporations to a related foreign corporation unless the related foreign corporation elects to treat the receipt of such payments as effectively connected income and thus taxable in the US (with such income taxed on a net basis) — Allowing immediate expensing of 100% of the cost of qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 (an additional year would be allowed for certain qualified property with a longer production period, and qualified property would not include any property used by a regulated public utility company or any property used in a real property trade or business) — Significantly modifying the treatment of net operating loss (NOL) carryforwards by repealing carryback provisions (except for a special one-year carryback for small businesses and farms for certain casualty and disaster losses, and a two-year carryback for life insurance companies), limiting the deduction of an NOL carryforward to 90% of a C corporation's taxable income for the year, and allowing NOLs arising in tax years beginning after 2017 to be carried forward indefinitely (currently limited to 20 years) subject to an interest factor to preserve its life (life insurance companies would be limited to a 20-year carryforward) — Repealing the corporate alternative minimum tax (AMT) — Limiting the deduction for net interest expense — Internal Revenue Code (IRC) Section 163(j) would be "revised" and expanded to limit the deduction for net interest expense of all businesses, thereby applying the limitation to net interest expense that exceeds 30% of adjusted taxable income, and new IRC Section 163(n) would limit the deduction for net interest expense of domestic corporations that are part of a worldwide reporting group (when both limitations apply, the one resulting in the greater interest disallowance would take precedence, and the disallowed interest would be available as a carryover for five years) — Eliminating various deductions and credits, including the IRC Section 199 domestic production deduction, the work opportunity tax credit and the new markets tax credit (terminated through disallowance of any additional allocation of credits with existing credits being available for up to seven years) — Preserving the research and development tax credit and Low-Income Housing Tax Credit without modification from current law — Expanding IRC Section 179 expensing by increasing the dollar limitation from $500,000 to $5 million and increasing the phase-out amount from $2 million to $20 million — Limiting like-kind exchanges to those involving real property, thereby repealing rules allowing deferral of gain on like-kind-exchanges of business and investment property (a transition rule would apply to like-kind exchanges currently underway) — Treating the disposition of self-created property (i.e., patents, inventions, model or design) as ordinary in character (currently such property is treated as a capital asset) and repealing the current rule that treats the sale or exchange of certain patents as long-term capital gain — Strengthening accountability rules that must be met in order to qualify for tax-exempt status The House bill would limit the tax rate on qualified business income of small and family-owned businesses conducted as a pass-through entity to a maximum rate of 25%; however, pass-through entities engaged in certain professional services, such as those providing legal, accounting, engineering, architectural and other similar services, would be ineligible for the reduced rate. The House bill would also allow small businesses to continue to write off loan interest, and would distinguish wage income from pass-through entity business income. Transition rules would be provided if the tax year included December 31, 2017. Key aspects of the House bill affecting individuals include: — Reducing the income tax rate brackets from seven to four — 12%, 25%, 35% and 39.6% (with the top rate applying to income of a married couple in excess of $1 million) — Doubling the standard deduction (for individuals, to $12,200, and for married couples, to $24,400) — Eliminating the personal exemption — Eliminating many itemized deductions (but retaining many deductions, most notably the deductions for charitable donations and a slimmed down mortgage interest deduction) — Eliminating the state income tax and sales tax deductions, but allowing a deduction of not more than $10,000 of domestic real property taxes (foreign real property taxes would be disallowed) — Limiting the deductibility of interest on new home mortgages of $500,000 or more and further limiting the exclusion of gain on the sale of principal residences — Repealing the individual AMT — Retaining tax benefits that encourage investment, higher education and retirement security — Consolidating the higher education tax benefits — Doubling the lifetime exclusion from the estate tax and the generation-skipping tax, and repealing both taxes beginning in 2024 (while retaining gift tax and the basis step-up at death) State income tax implications Many of the proposed federal tax reform measures, if enacted, will affect the income taxes imposed by state governments. Generally, most state income tax systems use federal taxable income as a starting point for state income tax computations, but do not automatically conform to federal tax rate changes. Thus, state income taxes would rise (immediately or in the near term) as the federal tax base expands, unless states align their tax rates with federal tax rate reductions. States that do not adjust their rates could significantly increase their tax revenues without taking any action. Focus on IRC conformity States generally conform to the IRC in one of several ways: (1) they automatically tie to the federal tax law as it changes (known as "rolling" conformity states); (2) they tie to the federal tax law as of a specific date (known as "fixed" conformity states); or (3) they pick and choose different federal tax law provisions and dates to which they will conform (known as "selective" conformity states). Most states generally define "state taxable income" as federal taxable income plus or minus certain additions or subtractions (such as adding back federal depreciation and substituting their own methods of depreciation). A handful of states, however, select sections of the IRC to which they will conform and then modify the actual provision (Arkansas, California and Mississippi are examples of states whose tax laws work in this selective manner). Twenty-two states1 currently adopt a "rolling" IRC conformity date and, as such, automatically conform to the IRC as enacted. Accordingly, if federal tax reform were to occur, these states generally would automatically adopt the federal tax changes unless the state chooses to decouple from the new federal provisions (for example, when facing significant IRC changes in the past, states have often enacted special provisions to decouple from some of the federal measures they sensed would be too costly, such as accelerated depreciation). Absent any change in state conformity or the state tax rate, taxpayers generally would see an immediate impact on their state effective tax rate. In contrast, another 20 states2 currently adopt a "fixed" IRC conformity date and thus generally would only incorporate changes to the IRC if they changed their conformity date to a date on or after the effective dates of federal tax reform provisions. Accordingly, for the federal changes to apply, these states generally would have to update their IRC conformity date.3 As such, taxpayers in these states generally will continue using the pre-federal tax reform version of the IRC to determine their state effective tax rate unless the state takes specific action to update its conformity date. The remaining five states4 with an income tax use a "selective" approach and adopt only specific provisions of the IRC, typically as of a specific fixed date. In these states, taxpayers generally could see a hybrid of the approaches used in the "rolling" and "fixed" conformity states that would affect their state effective tax rates. Regardless of which method a state uses, federal tax reform could have an assortment of effects at the state level depending not only on how they conform but also how each state responds to these federal tax law changes. For example, many states have had a robust history of proactively decoupling from federal bonus depreciation provisions, and it is expected that such decoupling efforts will continue with the House bill's immediate expensing of new equipment. Companies should be prepared to monitor and assess the effects of federal tax reform on their state tax profile across multiple financial reporting periods because the state approaches could be very different than what occurs for federal income tax purposes. Net operating losses The House bill would significantly modify the treatment of federal corporate NOLs by eliminating NOL carrybacks for most taxpayers, allowing NOLs arising in tax years beginning after 2017 to be carried forward indefinitely for most taxpayers (subject to an interest factor to preserve its life), and limiting usage of NOL carryforwards to 90% (rather than 100%) of the taxpayer's taxable income for the year, similar to the limitation now imposed under the current AMT (which would be repealed). Most of these changes would not be picked up by the states since most of them either use federal taxable income before the NOL deduction to determine state taxable income, or they compute the state NOL deduction separately. On the other hand, most states have long disallowed carrybacks of NOLs, and many have implemented at one time or another similar limitations on the utilization of NOL carryforwards. (In 2016, Louisiana, for example, implemented a 72% limitation similar to the federal proposal; California, New Jersey, Illinois and Colorado have either limited or suspended entirely NOL deductions for some time. Since adoption of its revised franchise tax in 2007, Texas has not allowed an NOL carryover at all.) Consequently, these new federal NOL limitations will affect only a handful of states that follow the federal NOL directly (e.g., Maryland and Virginia) or otherwise directly conform to IRC Section 172. Net interest expense deduction Section 3301 of the House bill would effectively "revise" IRC Section 163(j) and expand its application to limit the deduction for net interest expense of all businesses. Generally, this limitation would apply to net interest expense that exceeds 30% of the taxpayer's adjusted taxable income (ATI), a term essentially mimicking the EBITDA accounting term (i.e., "earnings before interest, taxes, depreciation and amortization"). The determination of ATI would be made at the tax filer level. For example, for a partnership, the limitation would be determined at the partnership level, not at the partner level. Any amounts disallowed under the provision could be carried over to the succeeding five tax years and would be an attribute of the business. The provision would include special rules to allow a pass-through entity's owners to use the unused interest limitation for the tax year and to ensure that net income from pass-through entities would not be double counted at the partner level. The provision would not apply to businesses with average gross receipts of $25 million or less, nor would it apply to regulated public utilities or real property trades or businesses. Since this new limitation would be part of the computation of a deduction used to determine federal taxable income and most states use federal taxable income as the starting point to determine state taxable income, absent legislative decoupling, the states would generally follow the provision, presumably including its five-year carryforward period. How the rule applies in specific states will depend upon how the state conforms to the IRC (i.e., if the state is a "fixed" conformity state, the provision would not apply until the state updated its date of conformity to the IRC; a "selective" conformity state would have to incorporate the provision for it to apply; and a "rolling" conformity state would automatically conform to the change unless the state chose to decouple from the provision). One interesting issue not addressed in the House bill is how the limitation percentage would apply in the context of the members of a federal consolidated group: Would the limitation be determined at the consolidated group level or to each member on a separate entity basis? Under currently law, IRC Section 163(j)(C)(6) and (7) require members of a federal affiliated group to be treated as if they were a single corporation for purposes of applying the current interest expense limitations. Treas. Reg. Section 1.163(j)-5 provides detailed rules drawing upon and cross-referencing to the federal consolidated return regulations to achieve this result. The House bill does not appear to include the affiliated group provisions of current IRC Section 163(j), and it is unclear whether the proposed limitations would apply on a separate-entity basis or a consolidated basis. Presumably, as the legislative process progresses, the applicability of the new IRC Section 163(j) limitations to affiliated or consolidated groups will be addressed and results similar to those under existing law would be carried over (i.e., the limitation would be determined at the affiliated group level just as under existing law). If so, since most states, even those that require or allow combined or consolidated returns, don't follow the federal consolidated return regulations, application by the states of this new business interest limitation might continue to determine any limitation at the individual entity level, conceivably resulting in wide disparities in the business interest limitation at the state level compared to the federal level (and even among the states). Moreover, to the extent that a state already provides for the addback of interest paid to related parties, the intersection of that state's related-party interest expense addback rule could introduce increased complexity that may need to be addressed by the state's legislature. Another interesting issue involved with this new limitation is the netting of certain interest income with interest expense as part of the overall net effect of the limitation calculation. Similar to the uncertainties described above involving application of the federal consolidated return regulations, would members of a federal consolidated group be allowed to offset certain interest income of one member with interest expense of another? If so, might there be benefits in separate-return states, for example, in locating interest income and interest expense within the same income tax entity to limit the impact of the limitation? Shift to territorial tax system A significant objective of federal tax reform is to make the US international tax regime more competitive with its foreign competitors. To further that objective, the House bill would move the US from its current worldwide system of taxation to the more prevalent territorial system, prospectively allowing a 100% deduction for dividends received from foreign corporate subsidiaries in which the US parent corporation owns at least a 10% stake. The House bill also includes a one-time transition tax whereby certain previously untaxed accumulated foreign earnings currently held by foreign corporate subsidiaries of US multinational corporations would be deemed repatriated under a special classification of Subpart F income and subject to tax at lower tax rates (12% for the portion of earnings held in cash and cash equivalents and 5% for illiquid assets). According to the House bill, for calendar year-end corporations, this one-time Subpart F income pick-up would occur on December 31, 2017 (but measured by the accumulated foreign earnings as of November 2, 2017, or December 31, 2017, whichever amount is greater). Under the provision, the US shareholder could elect to pay the transition tax ratably over eight years or less. In addition, as part of anti-base erosion efforts, Section 4301 of the House bill would prospectively tax potentially significant amounts of certain foreign income under modifications to Subpart F. Currently, states approach Subpart F income, and foreign dividends for that matter, in a variety of ways. While many states today exclude Subpart F income and foreign dividends from the tax base by way of a state modification to federal taxable income or through their own dividends received deduction,5 the states' disparate treatment of Subpart F income and foreign dividends, as well as the application of state-specific rules that disallow deduction of certain expenses related to non-taxable income, might result in unanticipated state income tax liabilities that differ from their federal treatment even under the proposed rules. Moreover, the direct percentage ownership of the foreign subsidiary from which the Subpart F income or dividends is derived, as well as the taxpayer's own state income tax return filing method (e.g., worldwide unitary combined, water's edge unitary combined, separate, etc.), could significantly affect how a taxpayer might be subject to state tax on such foreign-source income. Companies will need to carefully consider how the states in which they file returns and pay tax will conform to these significant changes to the federal taxation of international income. As companies begin to consider the federal income tax impact of these new rules, they should also immediately and concurrently consider the impact of the state tax treatment of these transactions, particularly since the magnitude of the resulting Subpart F income that would be recognized under the transition tax could be significant, and future distributions from foreign subsidiaries could be treated very differently by the states than they have in the past. Federal excise tax on certain payments to related foreign corporations Also as part of anti-base erosion efforts, Section 4303 of the House bill would impose a new 20% federal excise tax on certain payments made by US domestic corporations to a related foreign corporation unless the related foreign corporation elects to treat the receipt of those payments as effectively connected income (ECI), and thus taxable in the US (with such income taxed on a net basis). This provision would only apply to members of an "international financial reporting group," which is defined as a group of entities that: 1) prepares consolidated book financial statements; and 2) makes average annual payments to foreign corporations of over $100 million (averaged over three years). Since it is in the nature of a separate tax and not part of federal taxable income, this new excise tax would not be immediately incorporated by the states and would not draw a state tax. On the other hand, if the group elected to treat any of the amounts as ECI (which would be subject to the newly reduced 20% federal income tax rate), the election could have disparate state income tax results. For example, the foreign affiliate could be includable in a state water's edge report, although amounts could be eliminated through the state's combined reporting rules. In other cases, even if the foreign affiliate "elected" to treat the amount as ECI, it's questionable whether the foreign corporation would have Constitutional nexus for state tax purposes. Lastly, the provision is quite similar to the "addback" rules in many states that require the addback of certain payments to related parties. Consequently, the applicability of the inclusion in federal income as ECI, as well as an addback to the recipient by the state, could result in a "double" state tax on the same payment. The state tax results of this new "international financial reporting group" provision should be carefully considered. Repeal of credits Except for the research and development tax credit, the Low-Income Housing Tax Credit and certain foreign tax credits, the House bill would eliminate virtually every tax credit, including the work opportunity tax credit, various energy credits and the credit for rehabilitation for old and/or historic buildings, among others. Because these are federal credits against income tax and are not included in the determination of federal taxable income, the elimination of these credits would have little impact at the state level unless the state-developed tax credit program "piggybacks" on a federal tax credit being eliminated under the House bill. Piggyback programs generally adopt most, if not all, of the rules that apply to the federal tax credit program and commonly rely on the Internal Revenue Service for oversight. For example, many states offer historic rehabilitation credits that rely on the relevant sections of the federal tax code and approval processes to administer the state level program. It is unclear at this stage what will happen to these state tax credit programs if the federal "lead" program is repealed. In addition, the House bill would add new Section 76 to the IRC, which would generally require certain contributions to capital, including credits and incentives provided by state governments, to be recognized as gross income. The House bill also would repeal the provisions of IRC Section 118. Consequently, taxpayers that receive credits or incentives from state governments will have to consider both the federal and state tax impact of those credits. For a more detailed discussion of the House bill's repeal of the work opportunity tax credit, see Tax Alert 2017-1839. State tax deduction The House bill's proposed elimination of the federal individual income tax deduction for state income taxes (which has been part of the IRC since 1913) would significantly affect individuals at the federal level. At the state level, however, it would have little direct impact on individuals because most states require deducted state income taxes to be added back to federal taxable income to determine state taxable income. Likewise, the elimination of the alternative deduction for state sales taxes would have little direct impact at the state level as taxpayers in states that generally benefit from this deduction reside in states that do not impose a personal income tax. Despite these state and federal differences, the elimination of the state tax deduction for federal individual income tax purposes, coupled with reduced federal income tax rates, will likely have the indirect effect of making taxpayers feel as if they are paying much more in state taxes (in effect, for some taxpayers a nearly 50% increase in their overall state tax burden). As a result, these taxpayers could be more likely to pay greater attention to, and possibly be more emboldened to challenge, their state tax liabilities. Summary As federal tax reform progresses, taxpayers should keep the parallel state income tax implications in mind. Consequently, all taxpayers should focus in the coming months on utilizing a state-specific model to quantify the potential impacts of federal tax reform, as well as to identify and implement any applicable mitigation strategies (with particular time-sensitive focus on the transition tax). Corporate taxpayers should also educate their governmental affairs group as to the potential impact of federal tax reform from a state income tax perspective so that the appropriate message can be conveyed to state legislatures. Moreover, taxpayers in certain regulated industries, such public utilities, should start planning proactively with their regulators to identify mechanisms to recover additional state income taxes (if any). ———————————————
——————————————— 1 States that currently use a "rolling" IRC conformity date are: Alabama, Alaska, Colorado, Connecticut, Delaware, District of Columbia, Illinois, Kansas, Louisiana, Maryland, Massachusetts, Missouri, Montana, Nebraska, New Mexico, New York, North Dakota, Oklahoma, Oregon, Rhode Island, Tennessee and Utah. 2 States that currently use a "fixed" (or static) IRC conformity date are: Arizona, Florida, Georgia, Hawaii, Idaho, Indiana, Iowa, Kentucky, Maine, Michigan (note: taxpayers can make an election to use the current IRC date), Minnesota, New Hampshire, North Carolina, Ohio (personal income tax), South Carolina, Texas, Vermont, Virginia, West Virginia and Wisconsin. 3 A majority of fixed conformity states annually update their date of conformity to the IRC and usually do so within the first few months of each year. These states generally conform to the IRC on either the last day of the prior year or the first day of the current year, with a couple of states opting to conform to the date the state bill updating the IRC conformity date was enacted. Though it is likely that most of the fixed conformity states will update their date of conformity in order to couple to the proposed federal tax reform changes, especially those changes broadening the tax base, it is equally likely that some, if not most, of these states will decouple from certain taxpayer-friendly provisions that they may not be able to afford to conform. 4 States that currently use a "selective" IRC conformity approach are: Arkansas, California, Mississippi, New Jersey and Pennsylvania. 5 Such modification may be in response, at least in part, to precedent established in Kraft General Foods, Inc. v. Iowa Dept. of Rev. & Fin., 505 U.S. 71 (1992). In Kraft, the US Supreme Court held that Iowa's taxing of dividends received from foreign subsidiaries differently than dividends received from domestic subsidiaries violated the Foreign Commerce Clause of the US Constitution. | |||||||||||||||||||||||||||||
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