June 1, 2021
FIRST IMPRESSIONS | Treasury Green Book could have state income tax implications
On May 28, 2021, the Treasury Department released its FY 2022 explanation of the Biden Administration's revenue proposals (the Green Book), offering new details on the various proposals included in the President's "Made in America" tax plan. See Tax Alert 2021-9010 for an overview of the Green Book. The Green Book notably proposes significant changes to international tax provisions (see Tax Alert 2021-9011), as well federal credits, incentives and sustainability (see Tax Alert 2021-9012) and the federal income tax regime for individuals.
Many of these Green Book provisions, if enacted, could affect the corporate and individual income taxes imposed by state and local (collectively, state) governments. 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).
The state income tax implications of the Green Book generally would depend on how each state conforms to the IRC and to affected provisions, such as the global intangible low-taxed income (GILTI) regime under IRC Section 951A. States conform to the IRC in a variety of 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 Green Book proposals are enacted, rolling-conformity states generally would automatically adopt the IRC changes; 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 250 corporate deduction for foreign-derived intangible income (FDII), so a repeal of the FDII deduction would not affect tax computations in those states.
The more significant Green Book provisions with the potential to impact state income taxes include:
Several of these provisions, notably IRC Section 265, the SHIELD and proposals concerning disproportionate borrowing in the US, could result in additional limitations on the deductibility of business 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. Additionally, 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 new federal limitations.
Specific industries would face additional implications from the proposed tax changes in the Green Book. For example, the state income tax implications of proposed changes to the taxation of oil and gas extraction income, and the proposed repeal of certain oil and gas-related deductions (such as intangible drilling costs), will be of interest to companies in the energy sector.
The Green Book proposals would impact state corporate and individual income taxes not only because of how the states currently conform, 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, or are near to concluding, their legislative sessions and may not be positioned to immediately respond to these federal provisions. Understanding and communicating how these new federal tax developments impact state budgets will be of importance to state policymakers as the new legislative year approaches.
Businesses, too, should monitor and assess the potential effects of the Green Book proposals and relevant state tax legislation on their state tax profile across multiple financial reporting periods. Executives should also closely evaluate the potentially significant state implications of any transactions or activity undertaken in response to the provisions in the Green Book.