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The Biden Administration's proposed FY2024 budget, released March 9, 2023 (Budget), includes numerous tax changes that would affect businesses and high-net-worth individuals (see Tax Alerts 2023-0532 and 2023-0509). Most of the proposals in this year's Budget appeared in prior budget proposals or proposed legislation. While the prospects for enactment are dim this year, taxpayers should familiarize themselves with these proposals as they could appear as revenue offsets in later federal legislation, which could affect corporate and individual income taxes imposed by 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 the federal income determinations can affect state taxes. 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 taxes imposed under IRC Sections 11 and 1 (for corporations and individuals, respectively). Only Alaska¹ currently adopts the IRC Section 59A base erosion and anti-abuse tax (BEAT), for example, so the repeal of this tax would not directly affect tax computations in the other states. States also do not generally adopt the excise tax provisions under Subtitle D of the IRC; as such, the proposed rate increase for the excise tax on corporate stock buybacks does not have immediate implications for state taxes – though some states may permit a deduction for any such federal excise tax paid or accrued.

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. Upon enactment of a change in the IRC, rolling-conformity states that incorporate relevant IRC sections generally would automatically adopt the changes, while states with fixed conformity statutes 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. Finally, because the starting point for calculating “state taxable income” is typically subject to various modifications, taxpayers must consider specific conformity to IRC provisions in addition to states’ general adoption of the IRC.

Provisions in Budget proposals that could affect state income taxes

Notable provisions in the Budget proposals that could impact state income taxes for businesses would:

• Modify the GILTI regime to align with the global minimum tax rules under Pillar Two of the Base Erosion and Profit Shifting initiative of the Organisation for Economic Co-operation and Development (OECD)
• Replace the BEAT with an "undertaxed profits rule" (UTPR) that is consistent with the UTPR in the Pillar Two rules
• Repeal the deduction for foreign-derived intangible income (FDII)
• Create a new general business credit equal to 10% of eligible expenses incurred when onshoring a trade or business to the US
• Disallow deductions for expenses incurred when moving a US trade or business offshore
• Eliminate the exceptions in computing a controlled foreign corporation’s earnings and profits for purposes of IRC Section 952(c)
• Create a second type of US shareholder to include in income amounts determined with respect to non-taxed dividends
• Limit foreign tax credits on sales of hybrid entities
• Restrict deductions of excessive interest expense
• Modify the treatment of certain derivative transactions for foreign investors
• Change how certain business transactions are taxed (e.g., taxation of corporate distributions)
• Tax the capital income of high-income earners at ordinary rates, increasing the top rate from 20% to 39.6%
• Tax carried (profits) interests as ordinary income
• Make the IRC Section 461(l) limitation on excess business losses permanent and treat excess business losses carried forward as current-year business losses, rather than as NOLs
• Repeal gain deferral for like-kind exchanges
• Require 100% recapture of depreciation deductions as ordinary income for some depreciable real property

Many of the proposed changes relate to international tax provisions, such as GILTI and FDII; these changes would amplify the complexity of state tax reporting given existing variations in state tax treatment of these items.

While most states do not follow federal minimum tax regimes, the proposed UTPR – which is a minimum tax regime that is consistent with the UTPR described in the Pillar Two Model Rules – would operate through an expense disallowance mechanism. Under the Budget, both domestic corporations 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. To the extent these disallowed deductions increase federal taxable income, the UTPR could have a corresponding increase in the state corporate income tax base, raising potential questions about US Constitutional limitations on state taxation.² The proposal to disallow deduction of offshoring expenses could have similar state income tax consequences as the UTPR.

The UTPR and the disallowance of offshoring expenses – as well as the restriction of excess interest expense of entities that are members of an international financial reporting group – could result in additional limitations on the deductibility of interest expense for state income tax purposes. 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 would need to consider 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.

The Budget also includes 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 conforms to IRC Section 55, with some modifications;³ however, the state conforms to the IRC as of January 1, 2015,⁴ meaning that state legislative action would be necessary to adopt federal changes, if any, to that Code section.

Industry-specific Budget proposals

The Budget includes proposals specific to certain industries. 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 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.

Implications

The effects of the Budget would arise not only 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 legislatures would need to understand how these federal tax developments, if enacted, affect their state budgets. Businesses, too, should monitor and assess the potential effects of the Budget proposals and responsive state tax legislation on their state tax profile – closely evaluating the potentially significant state tax considerations for any transactions or activity undertaken in response to these proposed federal law changes.

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Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor

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ENDNOTES

¹ Alaska Stat. §§ 43.20.021(a), 43.20.300(a) and 43.20.340(5); Alaska Admin. Code tit. 15, § 20.135.

² See, e.g., Hunt -Wesson, Inc. v. Franchise Tax Bd., 528 US 458 (2000), in which the US Supreme Court found that a state statute disallowing certain interest expense deductions constituted impermissible taxation of income outside the state's jurisdictional reach in violation of the US Constitution. (“Although California's statute does not directly impose a tax on nonunitary income, it measures the amount of additional unitary income that becomes subject to its taxation (through reducing the deduction) by precisely the amount of nonunitary income that the taxpayer has received. Thus, that which California calls a deduction limitation would seem, in fact, to be an impermissible tax.”)

³ Cal. Rev. & Tax. Code §§ 23400, 23455, and 23455.5.

⁴ Cal. Rev. & Tax. Code § 23051.5(a), which cross-references Cal. Rev. & Tax. Code § 17024.5(a)(1) (a provision in California’s personal income tax law), wherein the current conformity date is codified.