Press Room: Tax Release
The Impact of Federal Tax Reform on State and Local Taxes
In December 2017, President Trump signed into law the Tax Reform Act of 2017 (the Act) which made extensive changes to the Internal Revenue Code (the Code). Many of these changes will also have a significant impact on state and local corporate income taxes.
State Conformity to the Internal Revenue Code
The starting point for analyzing the impact the Act will have on state corporate income taxes is how the state conforms to the Code. Most states either adopt the Code on a rolling basis or as of a fixed date. Twenty-five states and the District of Columbia conform to the Code on a rolling basis. These states will, generally, automatically adopt the changes in the Act. Twenty-one states conform to the Code as of a fixed date. Fixed date conformity states will, generally, require legislative action before they adopt the changes in the Act. The remaining states conform to only certain provisions of the Code. The impact of the Act in such selective conformity states will vary depending on which sections of the Code they adopt and as of what date(s).
Most state legislatures meet annually and are currently in session. Certainly, some state legislatures will address the corporate tax provisions of the federal legislation, but many states are also grappling with the personal income tax changes that impact their citizens and some states may wait until later in the year or even 2019 to fully address the corporate tax changes.
Highlights of Corporate Provisions in the Act
Corporate Rate Reduction and AMT
The Act reduces the federal corporate tax rate from 35% to 21%. States set their own corporate tax rates and this change in the Act will not have an impact on state income tax rates; however, the state tax burden will be a more significant part of the overall effective tax rate.
The federal legislation also repeals the corporate alternative minimum tax (AMT). States with alternative minimum taxes that are directly tied to the federal AMT could be impacted without legislative changes.
State Impact: Greater significance of state taxes to overall tax burden and piggyback state AMT statutes could be impacted without a legislative fix.
Interest Expense Limitation
The Act limits the deduction for net interest expense to 30% of adjusted taxable income. The limitation will likely be measured on a consolidated group basis and any disallowed interest is treated as an indefinite carry forward. Taxpayers in rolling conformity states will need to pay special attention to the impact of this limitation in separate filing states and combined states with filing groups that differ from the federal consolidated group. For more detail regarding the impact of the interest expense deduction see Federal Tax Reform: Amended Sec. 163(j) Interest Expense Limitation and State Tax Conformity Issues.
State Impact: The application of this limitation on separate company filing states should be closely reviewed.
Deduction for Cost of Qualified Business Property
While the Act may limit the amount of interest expense that can be deducted, it provides for a full deduction for the cost of qualified business property. Many states already decouple from bonus depreciation and may continue that trend by decoupling from the deduction for the cost of qualified business property. On the federal level, the impact of the interest expense limitation could be offset by additional depreciation deductions. It remains to be seen whether states will also decouple from the interest expense limitation deduction. The Pennsylvania Department of Revenue announced that it will deny depreciation deductions resulting from immediate expensing under federal tax reform in Corporate Tax Bulletin 2017-02. Shortly thereafter, Pennsylvania lawmakers introduced HB 2017 to rescind the Department of Revenue’s policy bulletin and allow additional depreciation deductions equal to the amount of depreciation that would otherwise be allowed under Secs. 167 and 168 without regard to Sec. 168(k).
State Impact: Will states decouple from full expensing of qualified business property, but not the interest expense limitation creating a mismatch for state purposes that doesn’t exist at the federal level?
Net Operating Losses
The Act also makes changes to the federal net operating loss (NOL) rules. It limits the NOL deduction to 80% of federal taxable income for losses arising in taxable years beginning after December 31, 2017. Many states have their own state-specific calculation of state NOLs and at first look it would appear that the few states that start their taxable income computation with Line 30 of the federal Form 1120 (after the federal NOL) and have rolling conformity would be impacted by this change; however, there are a group of states that are impacted by the federal 80% limitation and the indefinite carryforward period because of the manner in which they adopt Sec. 172.
State Impact: A close review of all state NOL rules is required to determine the impact that the reform will have on the usage of current and future NOLs.
International Provisions and Movement to a Participation Exemption System
Transition Tax on Foreign Accumulated Earnings and Profits
Some of the most extensive changes in the Act relate to the international provisions of the Code. The federal legislation moves the U.S. to a territorial tax system. Going forward, corporations will be permitted a 100% deduction from taxable income for the foreign source portion of dividends. As part of this change, there will be a one-time deemed repatriation transition tax on certain foreign accumulated earnings and profits (E&P). For U.S. shareholders of calendar-year foreign corporations, the transition tax generally applies to the 2017 tax year.
State Impact: The related state income tax issues are myriad. Consideration needs to be given to the following:
- Which entities will have an income inclusion from the deemed repatriation and what is each entity’s state tax footprint?
- What is the impact on net worth taxes due to change in value of foreign investment?
- How will actual repatriated funds (if any) be re-invested? Consider state credits and incentives opportunities.
- For states with rolling conformity to the Code, what are the state rules for subpart F income and Sec. 965(c), which may not meet the technical definition of subpart F income?
- Which nonconforming states will still require a separate (historic) subpart F income calculation? Some nonconforming states tax subpart F income and some do not.
- Are there constitutional impediments to the states taxing this income and/or is factor representation of the foreign entity required?
- Where will the income inclusion and corresponding deduction be placed on the federal Form 1120 and how will that impact state treatment of these items?
GILTI and FDII
In addition to the transition tax, the Act creates a new category of income from controlled foreign corporations (CFCs) under new Sec. 951A. A U.S. shareholder of any CFC would include in gross income for a tax year its global intangible low-taxed income (GILTI) in a manner generally similar to inclusions of subpart F income.
There is a corresponding deduction under Sec. 250 for foreign-derived intangible income (FDII) and part of the GILTI inclusion.
State Impact: GILTI is technically not subpart F income and will likely not be excluded under historic subpart F rules resulting in inclusion in taxable income in conforming states. Further, both the FDII and GILTI deductions under Sec. 250 were added to Part VIII of Subchapter B of Chapter 1 of the Code, Special Deductions for Corporations. As a special deduction under the Code, the deductions may not be included in states that start their taxable income computations with federal taxable income before special deductions (i.e., this could result in income with no exclusion).
Similar to the transition tax, there could be constitutional impediments to states taxing the GILTI inclusion.
The Tax Reform Act of 2017 is the most significant federal income tax legislation in over 30 years. The impact on state and local taxes should not be ignored as it could be significant. In the coming months and years states will make changes to their statutes to incorporate, decouple from or otherwise address the federal changes. Questions such as those posed above have already arisen and more are likely to arise during the implementation of the federal changes and states’ reactions to the changes.