June 16, 2021
Colorado legislature approves changes to combined reporting rules and other income tax rules
On June 7, 2021, the Colorado House approved Senate amendments to House Bill 1311 (HB 1311), which would change the state's combined reporting rules, including adopting a Finnigan approach to apportionment and implementing tax haven provisions. HB 1311 also would make other changes to the state's corporate and individual income tax provisions, including changing the computation of corporate net income and limiting the capital gains subtraction. Colorado Governor Jared Polis is expected to sign the legislation in the coming days.
HB 1311 would significantly change Colorado's combined reporting regime. Colorado's unique "3 of 6" test1 for determining which corporations can be included in a Colorado combined corporate income tax report, however, would not change. The legislature had considered repealing this test to simply require "members of a unitary business" to join in filing a Colorado combined report, but the proposed repeal of the "3 of 6" test was removed from the final version of HB 1311.
Changes to Colorado's combined reporting regime adopted by HB 1311 would apply to tax years beginning on or after January 1, 2022.
Tax haven provisions added
HB 1311 would retain the general rule under Colo. Rev. Stat. 39-22-303(8)(a) excluding a corporation from a Colorado combined return if it (1) conducts business outside the US; and (2) has at least 80% of its payroll and property located outside the US. HB 1311 would, however, amend Colo. Rev. Stat. 39-22-303(8) by adding subdivision (b) to require taxpayers to include any member of an affiliated group of C corporations2 in a combined group if the member is incorporated in a foreign jurisdiction for the purpose of tax avoidance.
The amended statute would presume that incorporation in a foreign jurisdiction is for the purpose of tax avoidance if the entity is incorporated in a "listed jurisdiction."3 A taxpayer would have the burden of proving, "to the satisfaction" of the executive director of the Colorado Department of Revenue (CO DOR), that the entity was incorporated in the listed jurisdiction for reasons meeting the economic substance rules defined in IRC Section 7701(o).
Finnigan rule adopted
Current law (Colo. Rev. Stat. 39-22-303(11)) utilizes a Joyce approach to determine the apportionment factors of a combined reporting group. Accordingly, only combined group members "doing business" in Colorado have sales represented in the numerator of the sales factor, with the denominator being the sales of the entire combined group. Starting in 2022, Colorado would adopt the Finnigan approach. Under the Finnigan approach, the numerator of the sales factor will include all sales sourced to Colorado regardless of the separate entity to which those sales are attributed.
Definition of "affiliated group" modified
Under current law (Colo. Rev. Stat. 39-22-303(12)(a)), an "affiliated group" is defined as one or more chains of includable corporations connected through stock ownership with a common parent. HB 1311 would amend Colo. Rev. Stat. 39-22-303(12)(a) to define an "affiliated group" as "one or more includable C corporations connected directly or indirectly through stock ownership with a common parent C corporation that is an includable C corporation."
This move to include direct or indirect ownership appears to expand the scope of the corporations that could be included in a Colorado combined reporting group. With the addition of this indirect stock ownership language to the definition of "affiliated group," taxpayers should consider if there are any changes to their Colorado combined group.
Computation of net income for corporations
Under Colo. Rev. Stat. 39-22-304(1)(a), the net income of a corporation is generally determined by reference to its federal taxable income (FTI) as defined in the IRC, subject to certain Colorado-specific modifications. HB 1311 would modify this computation, effective for tax years beginning on or after January 1, 2022.
HB 1311 would amend Colo. Rev. Stat. 39-22-304(1) by adding subdivision (b)(I) to modify the definition of FTI for corporations not incorporated in the US or included in a federal consolidated return. FTI would be defined as the corporation's income or loss, as determined from a profit and loss statement. The profit and loss statement, in turn, would have to be:
The corporation's income would include all income wherever derived and would not be limited to US-source income or effectively connected income. On an annual, reasonably and consistently applied basis, the entity would have to translate items of income, expense, gain or loss, and the related apportionment factors denominated in a foreign currency, into US dollars. Amended Colo. Rev. Stat. 39-22-304(1)(b)(II) would authorize the CO DOR Executive Director to adopt procedures to reasonably approximate these items or factors in US dollars.
HB 1311 would further amend Colo. Rev. Stat. 39-22-304(2) by adding subdivision (2)(j), which would limit the temporary 100% federal deduction under IRC Section 274(n)(2)(d) claimed for food and beverage expenses to 50% of the expense. This adjustment would be required for income tax years beginning on or after January 1, 2022, but before January 1, 2023. The adjustment provision would be repealed effective December 31, 2030.
Current Colo. Rev. Stat. 39-22-304(3)(j) prescribes a subtraction modification for any amount treated as a dividend under IRC Section 78. HB 1311 would change this subtraction modification by excluding any IRC Section 78 dividend received from a corporation incorporated in a tax haven for the purpose of tax avoidance (for discussion of Colorado's treatment of tax havens, see the earlier discussion on changes to Colorado's combined reporting rules).
HB 1311 would also add Colo. Rev. Stat. 39-22-304(p), which would prescribe subtraction modifications for any amounts included in FTI under IRC Sections 951(a) or 951A(a) (global intangible low-taxed income less any amount deducted under IRC 250(a)(1)(B)) for any controlled foreign corporation incorporated in a tax haven for the purpose of tax avoidance.
Capital gains subtraction limited
Under existing Colorado law (Colo. Rev. Stat. 39-22-518), qualifying Colorado taxpayers may deduct certain qualified capital gain income if it is included in their FTI. HB 1311 would limit this subtraction for tax years beginning on or after January 1, 2022.
Deductions before the limitations of HB 1311
Under existing law, the subtraction is available for tax years 2010 and forward in the following situations:
In either case, the subtraction may not exceed $100,000. A qualified taxpayer is any individual, firm, corporation, partnership, limited liability company, joint venture, estate, trust or group, or combination thereof, acting as a unit. To qualify for the subtraction, a taxpayer cannot have any overdue state tax liabilities or be in default on any contractual obligations owed to the state or to any local government within Colorado at the time the Colorado-source capital gain subtraction is claimed.
Limited deduction under HB 1311
HB 1311 would limit this Colorado-source capital gain subtraction for tax years beginning on or after January 1, 2022, by adding Colo. Rev. Stat. 39-22-518(a)(1.5). This would incorporate the language from the existing definition of a "qualifying taxpayer" but further limit that taxpayer to one filing a federal Schedule F, Profit or Loss from Farming for the tax year in which the capital gain arises. New Colo. Rev. Stat. 39-22-518(2)(b)(II)(C) would define "qualified real property" as real property classified by the county property tax assessor as agricultural land.4
Captive insurance companies
Current Colorado law exempts insurance companies subject to the Colorado tax on gross premiums from the Colorado corporate income tax. HB 1311 would amend Colo. Rev. Stat. 39-22-112(1) to exclude "disqualified insurance companies" from this exemption so they would be required to pay corporate income tax and not the premiums tax. New Colo. Rev. Stat. 10-1-102(6.5) would define a "disqualified insurance company" as a company that is (1) licensed as a captive insurance company under the laws of Colorado or the laws of another jurisdiction; and (2) has gross receipts for the tax year consisting of 50% or less of premiums from arrangements that constitute insurance for federal income tax purposes. Colo. Rev. Stat. 10-3-209(1)(a) would be amended to exempt a disqualified insurance company from the Colorado tax on gross premiums. Colo. Rev. Stat. 10-6-128, which requires captive insurance companies to pay gross premiums tax, would be similarly amended to exempt a disqualified insurance company from the premiums tax.
HB 1311 would create a temporary credit for a portion of the costs a business incurs by converting to a worker-owned cooperative, an employee stock ownership plan or an employee ownership trust.
In addition, HB 1311 would modify the individual income tax law as follows:
HB 1311 would also increase the earned income tax credit for specified tax years.
Corporations will need to consider the changes to Colorado's combined reporting rules and computation of net income that will apply to tax years beginning on or after January 1, 2022.
Taxpayers that own captive insurance companies will need to evaluate whether those companies are disqualified insurance companies under the changes implemented by HB 1311, which would make them subject to corporate income tax and potentially includable in their combined reporting group.
The adoption of the Finnigan approach might qualify as a tax increase, which would require a referendum vote under Colorado law. EY will continue to monitor developments in this area.
1 The "3 of 6" test appears in Colo. Stat. 39-22-303(11)(a) and requires a corporation to meet three or more parts of a six-part test regarding intercompany connections and transactions for the current and two preceding tax years.
2 For this purpose, a "C corporation" is defined to include any business entity defined as a corporation under the Internal Revenue Code (IRC) and related rules and regulations, without regard to whether the entity is subject to federal income tax.
3 The term "listed jurisdiction" would be defined to include the following jurisdictions: Andorra, Anguilla, Antigua and Barbuda, Aruba, The Bahamas, Bahrain, Barbados, Belize, Bermuda, Bonaire, British Virgin Islands, Cayman Islands, Cook Islands, Curaçao, Cyprus, Dominica, Gibraltar, Grenada, Guernsey-Sark-Alderney, Isle of Man, Jersey, Liberia, Luxembourg, Malta, Marshall Islands, Mauritius, Monaco, Montserrat, Nauru, Niue, Panama, Saba, Samoa, San Marino, Seychelles, Sint Eustatius, Sint Maarten, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Turks and Caicos Islands, U.S. Virgin Islands and Vanuatu.
4 For real property sold as a type of investment package, at least 75% of the real property sold in the package must be classified as agricultural land.
5 The cap would be $20,000 per beneficiary for single filers and $30,000 per beneficiary for joint filers.