April 1, 2022
FY2023 Budget proposals could have state income tax implications
On March 28, 2022, the Treasury Department released its FY2023 explanation of President Biden's revenue proposals (Budget proposals), which include several proposals that focus on reforming business and international taxation (see Tax Alerts 2022-9003 and 2022-0514). The Budget proposals are estimated relative to a baseline that incorporates all revenue provisions of H.R. 5376, the Build Back Better Act (as passed by the US House of Representatives on November 19, 2021), except proposed changes to the limitation on the federal deduction for state and local taxes (see Tax Alert 2021-2130 for a discussion of that House-approved bill and its state income tax implications). The Budget proposals, 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).
The state income tax implications of the Budget proposals 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. If the Budget proposals 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 or otherwise adopt legislation to that effect.
Because the starting point for calculating "state taxable income" is typically subject to various modifications, taxpayers also must consider specific conformity to IRC provisions. Most states do not adopt the IRC Section 59A base erosion and anti-abuse tax (BEAT), so the repeal of this tax would not directly affect tax computations in those states.
Budget proposals provisions that could affect state income taxes
Notable provisions in the Budget proposals that could impact state income taxes for businesses include:
While most states do not follow federal minimum tax regimes, as referenced previously, the UTPR is a minimum tax regime that operates through an expense disallowance mechanism. Under the Budget proposals, both domestic corporations that are part of a foreign-parented multinational group and domestic branches of foreign corporations would be denied US tax deductions to the extent necessary to collect the hypothetical top-up tax required for the financial reporting group to pay an effective tax rate of at least 15% in each foreign jurisdiction in which the group has profits. The UTPR deduction disallowance would apply only after the applying the Code's other deduction disallowances (e.g., IRC Section 163(j)), and would apply pro rata to all other allowable deductions. To the extent that the UTPR disallowance for a tax year exceeded the aggregate deductions otherwise allowable to the taxpayer for that year, the excess would be carried forward indefinitely until an equivalent amount of deductions is disallowed in future years. To the extent these disallowed deductions increase federal taxable income, the UTPR could have a corresponding increase in the state corporate income tax base. The proposal to disallow deduction of offshoring expenses could have similar state income tax consequences as the UTPR.
The Budget proposals also include a domestic minimum top-up tax that would apply to preclude the imposition of UTPR by other countries. State income tax conformity would depend on the manner in which such tax is enacted in the IRC. If enacted under IRC Section 55, the proposed additional federal tax could affect the handful of states that have enacted a corporate alternative minimum tax (AMT) relying on IRC Section 55. For example, California's corporate AMT directly ties to IRC Section 55; however, the state conforms to the IRC as of January 1, 2015, meaning that state legislative action would be necessary to adopt federal changes, if any, to that Code section.
Both the UTPR and the disallowance of offshoring expenses 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 and limited related-party interest expense deductions. State governments may need to enact legislation or provide specific guidance to harmonize existing interest-expense-addback statutes with these new federal limitations. A similar issue arose when IRC Section 163(j) was adopted 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.
Effects of Budget proposals on industries
Specific industries would also be impacted by the Budget proposals. For example, the state income tax implications of proposed changes to the taxation of insurance companies and fossil fuel producers would be of interest to companies in the financial services and energy sectors, respectively.
The potential state income tax effects of industry-specific proposals are not limited to tax base computations. Consider the Budget proposals on digital assets, which would change mark-to-market rules for dealers in securities. Some states, like California, rely on the IRC Section 475 definition of a "security" for purposes of state sales-factor-sourcing rules; changes to that Code section (which would distinguish actively traded digital assets from securities or commodities) may affect the sourcing of income from the sale of those digital assets (see Cal. Code Regs. tit. 18, Section 25136-2(b)(6)).
The Budget proposals could affect state corporate and individual income taxes. These effects not only stem from how the states currently conform to federal tax law, but also from 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 reforms. Currently, one-third of state legislatures are out of session and may not be positioned to immediately respond to these federal provisions. Understanding how these new federal tax developments affect 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 Budget proposals 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 Budget proposals.