Tax News Update    Email this document    Print this document  

On September 13, 2021, the House Ways and Means Committee released the tax portion of its reconciliation bill (HW&M proposal) and a section-by-section summary of the tax proposals (see Tax Alerts 2021-9020 and 2021-9019). The HW&M proposal, if enacted, could affect 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 HW&M proposal 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 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 the HW&M proposal is 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.

Provisions in the HW&M proposal that could impact state income taxes for businesses include:

• Adding new IRC Section 163(n), which would limit interest deductions for US corporations that are members of an international financial reporting group to the proportionate US share of the group's overall interest expense
• Modifying the IRC Section 163(j) limitation to apply at the partner- or shareholder-level for partnerships and S corporations, respectively
• Limiting the carryover period for interest expense disallowed under IRC Section 163(j) and (n) to five years
• Changing the calculation of GILTI, subpart F income and the corporate deductions under IRC Section 250 for GILTI and foreign-derived intangible income (FDII)
• Limiting the IRC Section 245A deduction to dividends received from controlled foreign corporations (CFCs) and allowing US shareholders to elect to treat foreign corporations as CFCs
• Modifying the treatment of certain losses from worthless securities
• Establishing an adjusted basis limitation for divisive reorganizations
• Permanently limiting excess business losses for noncorporate taxpayers
• Accelerating deduction limits for executive compensation under IRC Section 162(m)
• Delaying the effective date of mandatory capitalization of research and experimental expenditures

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.

Specific industries would also be impacted by the HW&M proposal. For example, the state income tax implications of proposed changes to the taxation of oil and gas extraction income will be of interest to companies in the energy sector, and the addition of "digital assets" to the IRC's constructive sale and wash sale rules would impact cryptocurrency users.

Conclusion

The HW&M proposal would 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 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 HW&M proposal 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 HW&M proposal.

———————————————