November 14, 2017 Senate tax reform proposal has different state tax impacts from House Ways & Means Bill On November 9, 2017, the Joint Committee on Taxation (JCT) released a conceptual explanation of the Senate tax reform proposals (referenced in this Alert as the Senate Plan) titled the "Description of the Chairman's Mark of the 'Tax Cuts and Jobs Act'" (JCT Report). The Senate Plan is scheduled for markup by the Senate Committee on Finance this week. Previously, the House Ways and Means Committee released its version of the tax reform bill titled the "Tax Cuts and Jobs Act" (H.R. 1 and referenced in this Alert as the House Bill) on November 2, 2017 (the state tax implications of which are addressed in Tax Alert 2017-1850). The House Ways and Means Committee subsequently amended and moved the House Bill through committee with a 24-16 vote. The House Bill is now in the House Rules Committee, and the full House is generally expected to vote on it as soon as later this week. Both the Senate Plan and the House Bill generally adhere to the "unified framework" issued earlier this summer by the Trump Administration and Congressional Republican leaders. The two differ, however, in the design of their provisions, their timing and, most importantly for state and local tax professionals, their respective impact at the state and local tax level. This Alert provides a summary of some of these differences and their impact from a US state and local (collectively, state) tax perspective. Overview of Senate Plan vs. House Bill In comparing the Senate Plan to the House Bill, the headline differences between the two include the following: — The Senate Plan would delay by one year the reduction of the corporate income tax rate to 20% until 2019, while the House Bill would reduce the rate for tax years beginning on or after January 1, 2018 (both would make the reduction permanent). — While both proposals would move the US federal income tax to a territorial tax system (from the current worldwide tax regime) and impose a one-time transition tax on certain previously untaxed accumulated foreign earnings to get there, the Senate Plan differs on its approach to preventing base erosion. — The Senate Plan retains the Work Opportunity Tax Credit and the New Markets Tax Credit, both of which would be repealed under the House Bill. — The Senate Plan makes many other changes to business and partnership provisions that are not included in the House Bill, some of which are described below. The Senate Plan also varies from the House Bill on the treatment of business income from pass-through entities (e.g., sole proprietorships, partnerships and S corporations) and the limitations on the deductibility of business interest. The Senate Plan provides a 17.4% deduction for individuals who receive income from certain pass-through entities, subject to a cap equal to 50% of Form W-2 wages paid. The deduction would not apply to income from certain professional services (such as legal, accounting, health, engineering, athletics and other similar professional services, as well as from a trade or business whose principal asset is the reputation or skill of one or more of its employees or owners, among others). The House Bill approaches pass-through entity taxation by establishing a maximum 25% individual income tax rate. Unlike the House Bill, the Senate Plan also creates new loss limitation rules whereby excess business losses of a taxpayer other than a C corporation would not be allowed for the tax year, but would be carried forward, if adjusted gross income exceeds $500,000 for married individuals filing jointly and $250,000 for other individuals (effectively meaning that Schedule E or C losses could not offset other income, such as interest, wages, pensions, etc.). As a result of these various changes, for federal income tax purposes, individuals will need to consider their unique circumstances in deciding whether the 20% corporate tax rate (in both the Senate Plan and the House Bill) will make operating as a C corporation more beneficial than operating as a pass-through. In making this determination, individuals will need to consider the second layer of tax on C corporation earnings and the 3.8% net investment income tax on dividends, especially given that the 17.4% deduction in the Senate Plan and the 25% tax rate in the House Bill will not apply equally to all types of income or all individuals. The Senate Plan follows the House Bill by imposing a limitation on the deductibility of business interest expense to the extent it exceeds 30% of the taxpayer's "adjusted taxable income" (ATI) plus its business interest income (certain regulated public utilities, real property trades or business, and small businesses would not be subject to this new limitation). However, while the House Bill's version of ATI essentially mimics the "EBITDA" accounting term (i.e., earnings before interest, taxes, depreciation and amortization), the Senate Plan instead would require deductions for depreciation, depletion and amortization (among others) in computing ATI, generally resulting in lower ATI and a correspondingly greater limitation on the business interest expense deduction than under the House Bill thereby raising significantly more revenue. Neither proposal contains a "grandfathering" provision. Thus, existing indebtedness would be subject to this limitation if enacted. Both proposals also impose an additional limitation that would limit deductible net interest paid by a US corporation (and a foreign corporation with US business) that is a member of a global group of corporations, but the proposals differ as to the criteria for determining who the members of the global group are for determining this additional interest limitation, as well as to the resulting limitation calculation methodology. Affected taxpayers would have to consider both the general and the global group interest limitations and apply the one that yields the greatest limitation when calculating their annual deductible interest expense. For individuals, the Senate Plan retains the current seven tax rate brackets (which are reduced to four under the House Bill). The Senate Plan, however, would reduce the top individual tax rate slightly to 38.5% while the House Bill retains the current 39.6% top individual tax rate. The Senate Plan also proposes doubling the current estate and gift tax exemption (from $5 million (adjusted for inflation, the current exclusion is $5.49 million) to $10 million). Unlike the House Bill, the Senate Plan would keep the estate and gift tax on the books. In addition, the state and local tax deduction (the SALT deduction) would be fully repealed under the Senate Plan, while the House Bill would mostly eliminate the SALT deduction but retain a $10,000 deduction for certain residential real property taxes. The $1 million cap on the home mortgage interest deduction would be left unchanged under the Senate Plan (it would be reduced to $500,000 under the House Bill). Similarly, the House Bill would eliminate the mortgage interest deduction for home equity line of credits (HELOCs) and second homes, while the Senate Plan would only eliminate it for HELOCs. Also, the Senate Plan would retain the medical expense deduction. Changes in the Senate Plan that are not in the House Bill include the following: — Repealing all itemized deductions subject to the 2% floor (e.g., home office deductions, license and regulatory fees, dues to professional societies and subscriptions to professional journals and trade magazines) — Reducing the amount of the deduction for dividends received from a domestic corporation to correlate with the reduction in the corporate rate — Repealing special rules for domestic international sales corporations — Shortening the recovery period for real property — Retaining but modifying and limiting the orphan drug credit — Reducing the credit for the rehabilitation of old and/or historic buildings — Eliminating the deduction for unused business credits — Creating a new elective safe harbor for worker classification (i.e., independent contractor v. employee classification) As the legislative process swiftly moves along, tax professionals are advised to carefully monitor the legislative developments in Washington as they progress. For a more in-depth summary of the Senate Plan, see Tax Alert 2017-1907. For a more detailed discussion of the individual provisions in the Senate Plan, see Tax Alert 2017-1928. For a more detailed discussion of the corporate and international provisions in the Senate Plan, see Tax Alert 2017-1917. For a more detailed discussion of the business and individual provisions in the Senate Plan, see Tax Alert 2017-1927. Select 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 Internal Revenue Code conformity States generally conform to the Internal Revenue Code (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 both the Senate Plan and House Bill's immediate expensing of 100% of the cost of qualified property under IRC Section 168(k), which will further exacerbate the differences between federal and state asset basis. 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 interest expense deduction Both the Senate Plan and the House Bill contain two new sets of rules for limiting the deduction of net interest expense for businesses — the general 30% business interest limitation (which applies to all businesses regardless of their form) and the base erosion global group interest limitation for corporations. These new limitations generally apply to both related- and unrelated party debt, and taxpayers are subject to the limitation that yields the greatest limitation. General 30% business interest limitation Like the House Bill, the Senate Plan would effectively "revise" IRC Section 163(j) and expand its application to limit the deduction for net interest expense of all businesses. Under the Senate Plan, this limitation would apply to business interest expense that exceeds 30% of the taxpayer's ATI plus business interest income, which is essentially the same as the House Bill limitation. However, while the House Bill's definition of ATI essentially mimics the "EBITDA" accounting term, the Senate Plan's definition of ATI differs from the House Bill in two notable respects. First, the Senate Plan also would include the 17.4% deduction for pass-through entity income in the computation for interest paid by pass-through entities. Second, the Senate Plan would require deductions for depreciation, depletion and amortization in computing ATI. Neither measure contains a "grandfathering" clause. Accordingly, interest on existing indebtedness would be subject to this limitation. Under both proposals, 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. While not entirely clear in the House Bill, the Senate Plan clarifies that the limitation is determined at the consolidated tax return filing level. The House Bill would limit the carryover of any amounts disallowed under the provision to the succeeding five tax years and would be an attribute of the business, while the Senate Plan instead provides for an unlimited carryforward of any disallowed interest. 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 annual gross receipts of $25 million or less during the prior three-year period in the House Bill and $15 million in the Senate Plan, nor would it apply to certain regulated public utilities or real property trades or businesses. The House Bill provides a special exception for interest on "floor plan financing indebtedness" (which is common among automobile and agricultural equipment dealers and other businesses), but that provision is not identified in the Senate Plan. Base erosion global group interest limitation In an attempt to address base erosion that results from excessive and disproportionate borrowing in the US, the Senate Plan follows the House Bill by also limiting deductible interest paid by a US domestic corporation (and a foreign corporation with US business) that is a member of a global group of corporations. However, the limitation calculation methodologies are different. Under the House Bill, in effect this provision generally would limit the current deductibility of net interest expense to the extent that the US corporation's share of the group's global net interest expense exceeds 110% of the US corporation's share of the global group's EBITDA. Under the Senate Plan, the deduction for interest paid or accrued by the US corporation is reduced by the product of the net interest expense of the US corporation multiplied by the debt-to-equity differential between the US corporation and the global group. The House Bill also differs from the Senate Plan in determining "relatedness" for purposes of determining the global group. Under the House Bill, the global group must have average annual gross receipts in excess of $100 million over three years and would include every member that appears in a consolidated financial statement under generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS) using a new defined term of "international financial reporting group." The Senate Plan, on the other hand, relies upon traditional affiliation principles under current federal tax law in IRC Section 1504, expanding the definition of "affiliated group" to include all corporations, including foreign corporations, regardless of where they are incorporated and reducing the ownership percentage from 80% to only 50% that share a common parent (even if that parent is incorporated outside of the US). Since these new interest expense limitations 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 carryforward period (indefinitely under the Senate Plan, and five-years under the House Bill). How the rule applies in specific states will depend upon how the state conforms to the IRC (i.e., a "rolling" conformity state generally would automatically conform to the change unless the state chose to decouple from the provision; a "fixed" conformity state generally would not apply the change until the state updated its IRC conformity date; and a "selective" conformity state generally would similarly have to incorporate the provision for it to apply). In addition, the creation of a new carryforward attribute for disallowed interest creates uncertainty as to whether states will apportion it and whether they will impose limitations under IRC Sections 381 and 382. Further, while the Senate Plan addresses how the limitation percentage applies in the context of an affiliated group filing a consolidated return, this is not addressed in the House Bill. Presumably, this discrepancy between the two measures will be resolved as the legislative process progresses, with the likely result that the limitation would be determined at the affiliated group level. If so, since most states, even those that require or allow combined or consolidated returns, don't follow the federal consolidated return regulations, the states might deviate from the federal treatment and seek to determine any limitation at the individual entity level, conceivably resulting in wide disparities in the business interest deduction limitations 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 previously 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? Finally, the application of these new net interest expense deduction limitations to S corporations, partnerships and other pass-through entities raises a variety of state income tax issues, including state conformity to federal pass-through treatment and states' disparate treatment of corporate versus individual-owned pass-through entities. International tax reform New transition tax 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 Senate Plan (like 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. Both the Senate Plan and the House Bill include 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 inclusion of Subpart F income and subject to tax at lower tax rates. Both the Senate Plan and the House Bill generally follow a similar methodology for this transition tax, but the tax rates under the Senate Plan would be 10% for the portion of earnings held in cash and cash equivalents and 5% for illiquid assets, while the rates under the House Bill (as revised during markup) are higher: 14% (from the originally proposed 12%) on the portion of earnings held in cash and cash equivalents and 7% (from the originally proposed 5%) for illiquid assets. Under the Senate Plan, this one-time Subpart F income pick-up would apply to a foreign corporation's last tax year beginning before January 1, 2018, but measured by the post-1986 tax-deferred accumulated earnings and profits (E&P) as of November 9, 2017, or other measurement date, as appropriate (the House Bill's beginning measurement date is the greater of the amount at November 2, 2017, or December 31, 2017). Under both the Senate Plan and the House Bill, the US shareholder could elect to pay the transition tax over eight years (at an increasing rate starting at 8% under the Senate Plan, and ratably under the House Bill). Further, under the Senate Plan (unlike the House Bill), a US corporation would be required to pay the full 35% rate on the deferred foreign earnings (less the taxes it already paid) if the US corporation inverted within 10 years after enactment. No foreign tax credits would be available to offset the tax in this instance. 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 also should 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. New anti-base erosion rules Similar to the House Bill, the Senate Plan has created a new anti-deferral regime that appears aimed at imposing a global minimum tax on certain excess returns of a controlled foreign corporation (CFC) on presumed "intangible" income. The operative provisions of this new category of CFC income are relatively similar to those in the House Bill (referred to as the "foreign high-return amount"); however, the minimum tax result is achieved by pegging this revenue-raising provision with a new deduction that would appear designed to encourage the realization of such excess returns related to the sale of goods and services to foreign customers directly through US operations. The Senate Plan thus creates both a "carrot" and a "stick" for the taxation of earnings from foreign sources. The "stick" would be in the form of a new category of CFC income called "global intangible low-taxed income" (or GILTI). GILTI would be computed at the US shareholder level on an aggregate basis, taking into account certain net "tested income" and "tested loss" of all of its CFCs. GILTI income would be the excess, if any, of the US shareholder's aggregate: (i) "net CFC tested income," over (ii) a deemed return on its CFC's tangible assets. That deemed return would be equivalent to 10% of the US shareholder's aggregate pro rata share of the "qualified business asset investment" (QBAI) of its CFCs (effectively measured as the US adjusted tax basis of the CFCs depreciable trade or business property). A US shareholder of a CFC with aggregate net CFC tested income in excess of that amount would have GILTI inclusions from the contributing CFCs subject to US tax in a manner generally similar to inclusions of Subpart F income. The net CFC tested income or loss of a CFC is generally its gross income for a tested year (not including certain items such as effectively connected income (ECI), gross subpart F income, etc.), offset by properly allocable deductions. A US corporate shareholder with a GILTI inclusion would be entitled to a deemed paid foreign tax credit (involving a formulary approach applied to foreign income taxes paid during the tested year solely on CFCs with net tested income during the year). The Senate Plan would create a new foreign tax credit limitation category for GILTI, and any excess credits in the category could not be carried forward or carried back to another year. The corresponding "carrot" in the Senate Plan would be the generation of a new deduction for US corporations for their "foreign-derived intangible income" (FDII) and GILTI inclusions. FDII equals the product of its "deemed intangible income" and the ratio that its "foreign-derived deduction eligible income" bears to its "deduction eligible income." The "foreign-derived" portion of eligible income is the portion of "deduction eligible income" that the corporation derived in that year in connection with property sold for foreign use or for services provided to foreign persons. "Deduction eligible income" is the excess of the US corporation's gross income (without regard to subpart F income, GILTI inclusions, CFC dividends, and foreign branch income) over allocable deductions. "Deemed intangible income" of the US corporation for a year is the excess of the "deduction eligible income" over its "deemed tangible income return" for the year (which equals 10% of the corporation's QBAI for the year). The allowable deduction would be 50% of the lesser of: (i) the sum of its FDII and GILTI inclusions, or (ii) its taxable income without regards to the deduction. The FDII deduction would, under a new 20% corporate income tax rate, generally subject a US corporation's FDII and GILTI inclusions to a federal effective tax rate of 12.5%. Taking the impact of these two carrot and stick provisions together (i.e., the FDII deduction and GILTI inclusions), it would appear the objective is to incentivize US corporations to source global intangible income directly to the US. Section 4301 of the House Bill, which would create a new category of Subpart F income, calls for an inclusion of a CFC's "foreign high-return amount," which is functionally similar to the Senate GILTI provision described previously. However, it arrives at a minimum effective rate on such income through the inclusion of 50% of any "foreign high-return amount" determined with respect to a CFC. The utilization of the FDII deduction is an overall broader benefit affecting all of the US corporation's intangible income whether directly or indirectly earned. The "foreign high-return amount" in the House Bill equals the excess, if any, of: 1) the US shareholder's CFCs' "net tested income"; over 2) a return on the CFCs' QBAI, reduced by interest expense. The return on QBAI, unlike the Senate GILTI provision, would be seven percentage points, plus the current federal short-term applicable federal rate (AFR). The other operative definitions are effectively the same between the House Bill and Senate Plan. For state income tax purposes, the FDII deduction in the Senate Plan would likely be incorporated into the US taxpayer's federal taxable income and, to the extent a state uses federal taxable income as its starting point, generally would be included in its state base income unless the state chose not to conform to the provision. States may find that the deduction amount does not correspond to the state's effective tax rate, and may want to address this disparity. The GILTI inclusion described in the Senate Plan, however, may be more problematic from a state income tax perspective since whether a state would follow it or not would generally depend upon how the state conforms to the provisions of Subpart F income. Since a US shareholder of any CFC must include in gross income for a tax year its GILTI income in a manner generally similar to inclusions of subpart F income, how a state conforms would require a careful analysis of its statutory conformity to the federal determination of taxable income and especially the Subpart F provisions (which would generally be the same state analysis for the Subpart F income under Section 4301 of the House Bill). Many states have fashioned provisions to incorporate Subpart F income into their tax regimes, and a similar approach generally would be required. While the FDII income in the Senate Plan would be relatively easy to trace for state apportionment factor purposes, because the GILTI income under the Senate Plan and the "foreign high-return amount" in the House Bill are recognized by a US shareholder that did not itself directly earn the income, questions arise as to how it would be treated for apportionment factor representation purposes (as well as raising potential allocation and unitary issues). Furthermore, in those states that have adopted tax haven legislation (e.g., Alaska, Connecticut, the District of Columbia, Montana, Oregon, Rhode Island, West Virginia), special carve outs for the GILTI income or the "foreign high-return amount" generally would have to be made in their water's edge reporting arrangements to avoid a double tax. Lastly, the treatment of foreign income in conforming states raise new questions as to whether a state can impose such taxes in light of Constitutional limitations, especially under the Foreign Commerce Clause,6 as well as the possibility that such taxes operate as tariffs and may be precluded under the Import-Export Clause. New inbound base erosion rule for certain payments to related foreign corporations Also as part of anti-base erosion efforts, both the Senate Plan and the House Bill would impose new base erosion rules for certain payments to related foreign corporations — the Senate Plan would create a new base erosion minimum tax while the House Bill would create a new 20% federal excise tax. The Senate Plan's base erosion minimum tax would apply to corporations (other than regulated investment companies (RICs), real estate investment trusts (REITs), and S-corporations) that are subject to US net income tax with average annual gross receipts of at least $500 million over a rolling three-year period, and have a "base erosion percentage" of 4% or more for the year. The tax is computed as the excess of 10% of the US corporation's "modified taxable income" over its regular tax liability for the year (further reduced by certain eligible credits). "Modified taxable income" is the corporation's taxable income adjusted by adding back "base erosion payments" that resulted in a "base erosion tax benefit." A "base erosion payment" is generally any amount paid or accrued to a related foreign person with respect to which a deduction is allowable (recent committee explanations appear to exclude payments that would be includible in cost of goods sold). The corporation's "base erosion percentage" therefore is the aggregate amount of its "base erosion tax benefits" (i.e., the amount of tax deductions allowed with respect to "base erosion payments") divided by its aggregate amount of allowable deductions. Although not entirely clear from the description in the JCT Report, the base erosion minimum tax appears to be a completely new tax regime that, like the excise tax in the House Bill, would not be directly incorporated into a determination of federal taxable income and thus, not directly incorporated into the state tax bases. On the other hand, many states already incorporate certain measures intended to limit the impact of "state tax base" erosion, such as combined reporting and related-party addback payments. Further, unlike the House Bill, the Senate Plan does not contain an elective provision for the foreign affiliates to treat amounts as ECI as more thoroughly described next. The Senate Plan's approach differs significantly from the House Bill provision. Under the House Bill in Section 4303, a new 20% federal excise tax would be imposed on certain payments (so-called specified amounts) paid by a US domestic corporation to a foreign corporation which is a member of the same "international financial reporting group" unless that foreign corporation elects to treat the income as ECI and thus taxable in the US on a net basis. An "international financial reporting group" is generally defined as a group of entities, with respect to any specified amount, that: 1) prepares consolidated book financial statements; and 2) makes average annual aggregate payment amounts over $100 million 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 specified 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 specified 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, which 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. Modifications to the dividends received deduction (no House Bill corollary) Under the Senate Plan, to reflect the lower corporate tax rate, dividends received deductions would be reduced to 65% (from the current 80%) for dividends received from a corporation of which the recipient corporation owned 20% or more, and to 50% (from the current 70%) for other dividends. "Qualifying dividends" (essentially from 80%-or-more-owned corporations) would continue to qualify for a 100% deduction, while dividends received from within a federal consolidated group would continue to be eliminated. From a state income tax perspective, these changes generally would only affect the state tax determination in those few states that conform to the federal dividends received deduction rules — that is, those states that directly rely upon federal taxable income after special deductions and net operating loss (NOL) carryforwards (e.g., Virginia, Maryland and Delaware) or that incorporate or follow the federal provisions. Most states have their own dividends received deduction rules, and these vary widely from state-to-state. Consequently, in many states, if this Senate Plan provision were adopted, unless the states chose to conform, it seems unlikely that this measure by itself would change the determination of state taxable income. The House Bill does not contain a similar provision. Determination of worker classification (no House Bill corollary) The Senate Plan would create a new elective safe harbor under which, if certain requirements are met, and for all IRC purposes, a service provider would not be treated as an employee, the service recipient would not be treated as an employer, a payor would not be treated as an employer, and compensation paid for services would not be treated as paid or received with respect to employment. The Senate Plan would also implement a withholding-at-source requirement of 5% for payments under $20,000 and increases the information reporting threshold from $600 to $1,000. In addition, the Senate Plan would revise the reporting thresholds that trigger reporting (and withholding) for payments of compensation for services required to be reported on Form 1099-K. Whether the amounts subject to federal withholding would trigger state income tax withholding is unknown, although the payment is defined for federal purposes as "a payment of wages by an employer to an employee," and many states tie state income tax withholding to the federal withholding requirements (e.g., generally by reference to IRC Section 3402 or by requiring state withholding if federal withholding is required). This safe harbor would apply for federal income and employment tax purposes, but would not necessarily be recognized under other federal laws (e.g., those enforced by the U.S. Department of Labor) or by the states for a range of provisions, including unemployment and workers' compensation insurance and those laws that protect wages and employment. For a more detailed discussion of the Senate Plan provisions of interest to employers, see Tax Alert 2017-1913. Other For a discussion of the state tax implications of other proposed tax reform changes, including NOL carryforwards (for which the Senate Plan and the House Bill have similar provisions) and the SALT deduction, see Tax Alert 2017-1850. For a discussion of the state tax implications of the repeal of certain tax credits, see Tax Alerts 2017-1839, 2017-1848 and 2017-1895. 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, which would impact the 2017 tax year). 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, particularly since state legislatures may act quickly in early 2018 during their regular legislative sessions (or in special legislative sessions) to respond to enacted federal tax reform measures. 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 to which 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 violated the Foreign Commerce Clause of the US Constitution by taxing of dividends received from foreign subsidiaries differently than dividends received from domestic subsidiaries. 6 See discussion of the Foreign Commerce Clause concerns in footnote 5. | |||||||||||||||||||||||||||||||
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