November 22, 2021
Tax provisions in House-passed reconciliation bill could have state income tax implications
On November 19, 2021, the US House of Representatives approved the Build Back Better Act (H.R. 5376) reconciliation bill (House bill), which includes social spending measures on health, climate, low-income tax credits and many other issues, paid with tax increases on corporations and individuals (see Tax Alert 2021-9027). The House bill, if enacted, could affect corporate and individual income taxes imposed by state and local (collectively, state) governments.
State conformity to federal tax changes
Generally, most state income tax systems use federal taxable income (corporate) or adjusted gross income (individual) as a starting point for state income tax computations, so changes to these federal income determinations can have state tax implications. By contrast, states do not automatically conform to federal tax rate changes, and most do not adopt minimum tax regimes that exist outside of the general rates under IRC Sections 11 and 1 (for corporations and individuals, respectively). States also do not generally adopt the excise tax provisions under Subtitle D of the IRC; as such, the proposed excise tax on corporate stock buybacks would not immediately have state tax implications.
The state income tax implications of the House bill generally would depend on how each state conforms to the IRC and to affected provisions, such as the regime for global intangible low-taxed income (GILTI) under IRC Section 951A. States conform to the IRC in various ways. Most either automatically incorporate the federal tax law as it changes (known as "rolling" conformity) or adopt the federal tax law as of a specific date (known as "fixed" conformity). There are also several "selective" conformity states, which adopt a hybrid of rolling and fixed conformity. Accordingly, if the House bill were enacted, rolling-conformity states generally would automatically adopt the IRC changes, while fixed-conformity states generally would only incorporate changes if and when they update their conformity date to a date on or after the effective date of the corresponding federal tax changes.
Because the starting point for calculating "state taxable income" is typically subject to various modifications, taxpayers also must consider specific conformity to IRC provisions. For example, many states do not adopt the IRC Section 59A base erosion and anti-abuse tax or the IRC Section 245A corporate deduction for the foreign-source portion of certain dividends received, so changes to these provisions would not directly affect tax computations in those states.
House bill provisions that could affect state income taxes
Notable provisions in the House bill that could impact state income taxes for businesses include:
Many of the proposed changes relate to international tax provisions, such as GILTI, FDII and subpart F income; these changes would amplify the complexity of state tax reporting given existing variations in state tax treatment of these items. In addition, the proposed changes impacting IRC Section 163 could result in additional limitations on the deductibility of interest expense. Such provisions would add complexity to the state income tax base, particularly if they invoke single-entity principles of a federal consolidated return, which states often do not follow in determining state taxable income. Moreover, states have historically challenged related-party transactions like interest expense deductions, and many states already limit these deductions. State governments may need to enact legislation or provide specific guidance to harmonize existing addback statutes for interest expense with these new federal limitations, like how many states responded to IRC Section 163(j) under the Tax Cuts and Jobs Act of 2017. Businesses seeking to maintain or increase the state tax efficiency of their debt should consider the potential impact of these proposed federal limitations.
Also, while most states do not follow federal minimum tax regimes, as referenced previously, state income tax conformity to the proposed 15% CAMT based on book income could be an issue in the handful of states that have enacted a corporate AMT that relies on IRC Section 55. For example, California's corporate AMT directly ties to IRC Section 55, where the proposed CAMT would reside. Note, however, that the state conforms to the IRC as of January 1, 2015, meaning that state legislative action would be necessary to adopt the CAMT.
Effects of House bill on industries
Specific industries would also be impacted by the House bill. For example, the state income tax implications of proposed changes to the taxation of oil and gas extraction income would be of interest to companies in the energy sector, and the proposed addition of "digital assets" to the IRC's constructive sale and wash sale rules would impact cryptocurrency users.
The House bill could impact state corporate and individual income taxes, not only because of how the states currently conform to federal tax law, but also because of how state lawmakers modify state tax laws in response to federal changes. State policymakers would need to react to federal changes or could choose to implement their own tax reform. As of today, most states have already concluded their legislative sessions and may not be positioned to immediately respond to these federal provisions. Understanding how these new federal tax developments impact state budgets will be important to state policymakers as the new legislative year approaches.
Businesses, too, should monitor and assess the potential effects of the House bill and relevant state tax legislation on their state tax profile. Executives should also closely evaluate the potentially significant state implications of any transactions or activity undertaken in response to the provisions in the House bill.