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Nearly two years after Congress passed and President Trump signed Tax Cuts and Jobs Act of 2017 (U.S. tax reform) into law, many states are still coming to grips with the changes. It can be challenging for tax departments to keep up with all state developments in addition to all other responsibilities. Understanding the complexities and implications of U.S. tax reform on state and local income taxes can be an afterthought, causing many tax departments to prioritize the most-impacted areas first. However, some of the changes including the lower corporate tax rate of 21 percent and certain base-broadening provisions, have potentially far-reaching effects on state and local income taxes.
Most states use federal taxable income as the starting point for calculating state corporate taxable income but did not change their state tax rates in conjunction with the decrease to the federal rate. As a result, the base-broadening measures of U.S. tax reform often flow through to states, while the rate reduction does not. Therefore, a company that pays less federal income tax in light of U.S. tax reform may not have a corresponding reduction in state income taxes. However, each state’s tax regime is unique. Even though most states rely on the federal income tax regime, including the Internal Revenue Code (“IRC”) and the Treasury regulations thereunder, there are differences which can create a state result that varies significantly from the federal result. These differences can arise for various reasons, such as a state’s reliance upon an earlier version of the IRC, decoupling from specific IRC federal provisions, differences in the treatment of non-corporate entities, or application of the federal consolidated return regulations.
The passage of U.S. tax reform included the promulgation of certain international provisions aimed at raising revenue and combating base erosion. For example, the global intangible low-taxed income (“GILTI”) provisions impose tax by creating a new category of foreign-source income where that income is taxed at less than a 13.125 percent rate in a foreign country. Income that qualifies as GILTI for federal purposes is taxed at a rate of 10.5 percent and taxpayers are allowed a credit for 80 percent of foreign taxes paid on such income. In addition to changing how foreign income is recognized and taxed, tax reform also amended the rule which limits the deduction for business interest expense. IRC Section 163(j) generally limits business interest expenses to the taxpayer’s business interest income plus 30% of its adjusted taxable income and certain other interest. The amendment to the section 163(j) limitation causes more taxpayers to be limited in their deduction for business interest expense. In states that do not conform to GILTI and/or IRC section 163(j) or conform to an older version of the IRC that doesn’t incorporate these provisions, interesting and complex issues arise with respect to how each respective state will decide to treat GILTI and any allowable interest deduction.
While each state may in some way incorporate or reference the IRC, each state has sovereign authority to adopt or tailor IRC provisions to meet its specific needs. As such, there has been a flood of state responses to U.S. tax reform as many states have passed legislation or promulgated administrative rules or guidance addressing GILTI and other provisions impacted by tax reform. For example, historically most states allowed a full or partial deduction for foreign dividends received and subpart F income, a category of foreign-source income with similarities to GILTI. As anticipated, some states have chosen to treat GILTI in the same or similar manner as subpart F income and/or foreign dividends. Other states, however, have created entirely new rules to tax GILTI. Maryland, for example, released guidance instructing taxpayers to compute the Maryland apportionment factor by including the gross amount of GILTI in the denominator of the sales factor. However, because GILTI is income attributable to intangible property, the state requires a portion of GILTI to be included in the numerator of the sales factor based on the average of the property and payroll factors.
From a practical perspective, although there are nuances from jurisdiction to jurisdiction, the state income tax treatment of GILTI for corporations can be simplified into categories. First, certain states do not conform to the provisions requiring the inclusion of GILTI in gross income, either because the state expressly decoupled or as a result of the state conforming to a version of the IRC that pre-dates tax reform (e.g., California and Texas). Second, there are states that allow a full subtraction to be applied to GILTI (e.g., Florida and Georgia). Third, there are other states that allow a partial subtraction for GILTI (Massachusetts and Maine). And fourth, there are states that do not provide any subtraction for GILTI. Currently, there are very few states that tax GILTI without conforming to the fifty percent deduction under IRC section 250A allowed for federal income tax purposes to be applied to GILTI (e.g., Alaska and the District of Columbia).
Similar to GILTI, the state corporate income tax impacts of IRC section 163(j) can be distilled into various categories. First, states that expressly decouple from IRC section 163(j) or conform to an older version of the IRC and allow interest to be deducted either without limitation or through applying the rule limiting the deductibility of interest under the prior version of section 163(j) (e.g., Georgia and Connecticut). Second, there are states that conform to IRC section 163(j) (e.g., Illinois and Massachusetts). Third, there are a minority of states that have enacted a state specific partial modification to the section 163(j) limitation (e.g., Virginia).
Although it can be challenging for tax departments to stay current on state developments in an ever-changing state tax landscape, the onslaught of state responses to tax reform should be encouraging to companies. When there is ambiguity regarding a state’s treatment of a new federal provision, the lack of state guidance can cause uncertainty for taxpayers and may lead to risks associated with uncertain tax positions. For example, in a state that conforms to GILTI by virtue of its conformity to the IRC and has not yet made clear whether GILTI is eligible for a state deduction, affected taxpayers are forced to apply the state’s existing tax rules (which were enacted without contemplation for this new category of income) to determine what portion of that income should be subject to tax. When states enact legislation or release administrative guidance, taxpayers are typically provided with a level of certainty where GILTI and other new federal provisions might not fit well within the existing state tax regime.
By tracking state conformity to the relevant provisions of the IRC and active monitoring of state developments, calculating the state modifications for GILTI and IRC section 163(j) becomes much more manageable. Tax departments were often stretched too thin before U.S. tax reform took effect and are continually faced with the task of doing more with less resources. In the wake of these seismic federal changes, state tax compliance may seem like an insurmountable task for taxpayers with a large state filing footprint. Companies facing such challenges should not go it alone and should consult practitioners with specialized state tax expertise who have the capability of leveraging innovative technology and can ease the burden on strained tax departments. In a state tax landscape that is dynamic and ever-changing, the collaboration between a company and its trusted state tax advisor is vital. Understanding the impact of state tax changes on your company as they occur in real time, allows tax departments to be nimble, adaptive and proactively comply with those rules and plan to reduce any unnecessary burdens.
Valerie Dickerson is Deloitte Tax partner, managing partner, Washington National Tax Multistate at Deloitte Tax LLP and Tyler Greaves is Manager at Deloitte Tax LLP.