In the months since the Tax Cuts and Jobs Act (the Act or TCJA) became law, much of the focus has been on the federal changes enacted as part of the legislation. However, state income taxes are also affected by the vast changes created by the Act. Our second edition of the Tax Reform Progress Report provides insights as to how states are adapting. This issue covers the state income tax impact of the repatriation tax, the expanded cost recovery provisions, the business interest expense limitation and the modifications of the net operating loss (NOL) deductions. With states struggling to raise revenues, it is important to monitor how they will adjust to the TCJA.
General state conformity
A state’s method of conformity to the Internal Revenue Code (IRC) dictates how much of the TCJA will apply to its income tax code. States may conform to the IRC in the following four ways:
- Rolling conformity: states automatically adopt the current IRC as it is updated and revised, unless the state has pre-existing law that provides for decoupling from specific code provisions
- Annual conformity: states adopt the IRC as of a certain date (e.g., Dec. 31, 2017) and generally do so affirmatively on an annual basis
- Fixed conformity: states, at the end of their 2018 legislative sessions, will affirmatively adopt the IRC as of Dec. 31, 2017; however, from a practical perspective, it may take some of these states (e.g., Texas, New Hampshire) several years to adopt the IRC as of Dec. 31, 2017
- Remaining: states will continue to follow or decouple from specific code sections (e.g., section 168) as they have historically done
Section 965 repatriation tax
The impact on a corporation’s state income due to the deemed income inclusion under section 965 largely depends on each state’s conformity rules, whether a state taxes Subpart F income and if a state would provide for a deduction of any deemed income inclusion. The new section 965(a) requires the inclusion in Subpart F income of the undistributed earnings and profits of 10 percent-or-more-owned foreign corporations. A deduction for this “deemed” income is provided under section 965(c) that will reduce the effective federal tax rate to 15.5 percent on deferred earnings held in the form of cash and cash equivalents and 8 percent deferred earnings held in noncash assets. Although most states have not completed their 2018 legislative sessions, we offer the following observations:
- In rolling conformity states, where the current IRC was adopted for 2017 calendar taxpayers, many states exclude or allow a deduction from the state tax base for Subpart F income. You will need to review each state in which you do business to determine the applicable treatment.
- For fixed conformity states, this one-time deemed income inclusion would not appear in state taxable income until the Dec. 22, 2017, IRC is adopted. Since the repatriation dividend is essentially set to occur at Dec. 31, 2017, states that fail to update their IRC reference to that date for tax years beginning prior to Jan. 1, 2018, will lose their ability to tax it.
- An unexpected benefit may occur for taxpayers in states that provide for a deduction or exclusion of income subject to repatriation tax but do not decouple from the section 965(c) deduction in determining the taxpayer’s state tax base. This would occur if a state allowed a corporation to subtract the full section 965(a) repatriation amount from gross income under its own dividends-received deduction while only picking up the net repatriation dividend reduced under section 965(c) due to its starting point in defining corporate taxable income. The result will be a double deduction.
- Apportionment/sales factor considerations:
If income from a deemed income exclusion is included in state taxable income, it should be determined whether such income/receipts are included in the sales factor.
- In a state that does not tax income from a deemed repatriation, the impact on the sales factor still needs to be addressed when the actual cash is subsequently distributed into the U.S.
- In states that will subject all or a portion of the deemed income inclusion to taxation, an open issue is whether they will adopt an eight-year payment plan and the S-corporation deferral option allowable for federal tax purposes.
- Existing NOLs will be reduced in states that subject all or a portion of the deemed income inclusion to taxation. NOL and credit carryovers will also be affected but can serve to offset the cash tax impacts of the repatriation income.
- Some states may tax the earnings pursuant to section 965(a) net of the deduction for a portion of those earnings provided under section 965(c) as Subpart F income, with the same exclusions and deductions that apply to their current or deemed Subpart F inclusions.
- The taxpayer’s state filing method, e.g., worldwide combined, water’s-edge or separate, may affect how the taxpayer Subpart F income is subject to the tax on the state level.
- States that require an addback of foreign income taxes paid resulting in a foreign tax credit for federal income tax purposes, e.g., Washington, D.C., Georgia and Massachusetts, may create additional tax due at the state level. It is unclear how the haircut on the foreign income tax credit under section 965(g) will be treated for state tax purposes.
- Based upon the mechanics of the 2017 U.S. Form 1120 as well as the section 965 Transition Tax Statement, it is yet to be determined whether or how all states will revise their corporate income tax forms for 2017 and forward. Since most states start with line 28 or 30 of the Form 1120, the deemed income inclusion would not be included in the state taxable income starting point. Of course, state form instructions do not constitute authority for tax position purposes. Rather, this represents a mechanical problem states must address.
A majority of states eliminate Subpart F income through an exclusion, a subtraction modification or a deduction for dividends received. However, in some states (Alaska, Colorado, Kansas, Louisiana, Massachusetts, Maine, Minnesota, Montana, New Hampshire, North Dakota, Oklahoma, Oregon, Utah and Vermont), all or a portion of repatriation income may be subject to state income tax due to the rolling conformity provisions or as determined by the percentage of ownership.
Of the states on this list, four (Colorado, New Hampshire, Oklahoma and Vermont) provide for a worst-case scenario which may include Subpart F income in their state income tax base and not allow for a favorable deduction or subtraction. A less onerous result of this tax may occur in Massachusetts, where a subtraction modification equals 95 percent of the Subpart F income received from a 15 percent-or-more-owned foreign corporation. Finally, Minnesota provides for an 80 percent Subpart F income subtraction from a 20 percent-or-more-owned foreign corporation.
The following are examples of some states’ guidance on how they will treat conformity to section 965:
- Illinois – FY 2018-23, a March 21, 2018, Illinois Department of Revenue Informational Bulletin, indicates the subtraction modification for foreign dividends will exclude a portion of the increase from Illinois base income for certain taxpayers. Further, it affirms Illinois does not follow either the election under section 965(h) to pay the liability in installments over eight years or the election under section 965(i) in the case of S-corporation shareholders to defer payment of the tax liability until the taxable year which includes a triggering event. FY 2018-23 also emphasizes the failure to accurately report section 965 net income and pay the associated tax by the original due date of your tax return could result in penalties and interest. Due to the separate nature of the section 965 Transition Tax Statement, the income reported is not included in federal taxable income; however, it must be included when determining state base income. See the revised instructions associated with your specific return type for information on how to report section 965 net income. Taxpayers who have already filed a 2017 Illinois income tax return and did not include section 965 net income must amend their return to account for that income.
- Virginia – H.B. 154 signed into law Feb. 23, 2018, conforms to the IRC as of Feb. 9, 2018, with exception to any provision of the TCJA that affects the computation of federal taxable income of corporations for taxable years beginning after Dec. 31, 2016, and before Jan. 1, 2018. As such, Virginia conforms to section 965 as it affects the computation of federal taxable income of corporations for tax years beginning Jan. 1, 2018.
- Wisconsin – 2017 Act 231, published April 4, 2018, updates the state’s IRC reference to Dec. 31, 2017, for tax years beginning Jan.1, 2018. It excludes section 965 from the TCJA provisions adopted for individual income and corporation franchise tax purposes.
Expensing of asset acquisitions
State allowance of the full and immediate expensing provisions permitted by the TCJA under sections 168(k) and 179 depends on the state’s conformity to the IRC. The Act expands bonus depreciation by adding new categories of “qualified property” and extends it through 2026. Currently, approximately 15 rolling conformity states automatically adopt the TCJA’s section 168(k) bonus depreciation provisions. Further, most states adopt section 179 immediate expensing in some form or fashion. Depending on their conformity to the TCJA’s other sections, e.g., interest deduction limitation of section 163(j), net operating loss restriction of section 172 and the repatriation toll tax of section 965, states with rolling or specific conformity to bonus depreciation and section 179 may consider decoupling due to the direct impact on their budgets.
Numerous states decouple from sections 168(k) and 179 by requiring the addition of federal bonus depreciation and immediate expensing deductions back to federal taxable income. However, the following states generally conform to section 168(k) federal bonus depreciation due to the rolling conformity: Alabama, Alaska, Colorado, Delaware, Kansas, Louisiana, Nebraska, New Mexico, North Dakota, Missouri, Montana, Oklahoma, Oregon, Utah, and West Virginia.
Although most states have not completed their 2018 legislative sessions, we can offer the following observations:
- We envision that any section 168(k) conforming states with tax revenues negatively impacted by full expensing may decouple or limit the provision in some way to maintain the integrity of their tax base.
- Similarly, if the increased section 179 immediate expensing limits and expanded qualified property types materially compromise a state’s tax base, these states may also consider decoupling or limiting the applicability of section 179.
- For the states that decouple from either expanded federal capital cost recovery provision, there will be a difference between the basis in assets for federal and state income tax purposes, which become apparent when the property is sold, exchanged or disposed. This adds additional complexity and record-keeping requirements.
The following are examples of some states’ guidance on how they will treat conformity to sections 168(k) and 179:
- Pennsylvania – In Corporation Tax Bulletin 2017-02 issued Dec. 22, 2017, the Pennsylvania Department of Revenue announced that it will decouple from section 168(k) as modified by the TCJA and require an addback of 100 percent depreciation deducted for qualified property acquired and placed in service after Sept. 27, 2017, for federal income tax purposes. However, the DOR will continue to allow depreciation deductions for property on which bonus depreciation is claimed.
Note: On March 14, 2018, the Pennsylvania House of Representatives passed H.B. 2017, which would nullify the DOR’s Corporation Tax Bulletin 2017-02 and allow depreciation deduction over the life of the property in accordance with sections 167 and 168, but still decouple from TCJA’s full expensing provisions provided in section 168(k). This bill is under consideration by the state Senate. A competing bill in the Pennsylvania Senate, S.B. 1056, would allow conformity to the section 168(k) full expensing provisions. It was referred to the Appropriations Committee.
- Virginia – H.B. 154, signed into law Feb. 23, 2018, provides that Virginia conform to the IRC as of Feb. 9, 2018, but decouples with respect to various provisions including section 168(k).
- Wisconsin – 2017 Act 231, published April 4, 2018, updates the state’s IRC reference to Dec. 31, 2017, for tax years beginning Jan.1, 2018. It excludes section 168(k) from the TCJA provisions adopted for individual income and corporation franchise tax purposes. However, it maintains current conformity with section 179 expensing.
Section 163(j) business interest expense limitation
Under the TCJA, limitations are placed on the deductibility of business interest expense. The effect of section 163(j) on an entity’s taxable income, again, depends on each state’s conformity rules and decoupling provisions. Although most states have not completed their 2018 legislative sessions, we have the following observations:
- Computing “adjusted taxable income” (ATI) may not be compatible at the state level, potentially requiring a separate calculation (similar to decoupling from federal net operating loss and depreciation rules). For example, state and local bond interest income exempt for federal purposes may have to be included when calculating a state’s ATI limit, while U.S. government interest income would be eliminated.
- Several separate company states have existing provisions requiring an addback of related-party interest expenses. In addition, certain combined reporting states like Massachusetts and Illinois have addback statutes that affect 80-20 corporations and foreign entities that are not included in their water’s-edge return. Since section 163(j) applies to both related party and third-party debt, for taxpayers filing in states with addback provisions that conform to section 163(j), the same interest expense may be subject to two separate disallowance methods.
- State return filing methodology (e.g., separate, unitary combined, consolidated) may present complications and differing results during compliance.
- Since section 163(j) does not specifically define the term “taxpayer” and states have varying definitions of this term, there may be a disconnect as to how the state rules should be applied. For instance, in a separate company state, the term “taxpayer” may define each specific “stand-alone” filer. However, in a state with a mandatory combined unitary filing, the term may refer to the entire filing group, thus creating an ambiguity as to how the section 163(j) limitation should be applied. While the U.S. Treasury is developing guidance on section 163(j) as it applies to consolidated return filers, the IRS has stated, in Notice 2018-28, the business interest expense limitation will apply at the consolidated group level, but likely not at the affiliated group level. States allowing or requiring combined or consolidated returns may or may not adopt the Treasury’s proposed interest limitation rules. Alternatively, they could enact the rules in a modified form, for example, substituting unitary ownership requirements for federal affiliated group ownership standards. In addition, the Treasury has yet to comment on how interest expense on a consolidated return will be treated when the consolidated group contains some businesses that are afforded exceptions to the interest limitation, e.g., real property businesses or businesses with floor plan interest.
- States may decouple from special industry provisions or provide their own separate requirements. In the states with uniformity clauses, such as Pennsylvania, this may lead to potential challenges as to why selected industries are being given preferential tax treatment.
- While currently suspended in accordance with Notice 2017-38, the application of final and temporary section 385 regulations and state conformity to these regulations should remain a consideration to determine whether certain debt may be re-characterized as equity.
- The creation of a new carryover attribute under section 163(j) has several state implications:
For compliance and tax provision purposes, an adjustment may need to be made to the states that decouple from the section 163(j) language permitting disallowed interest expense to be carried forward indefinitely at the federal level. This could give rise to timing differences where interest is deducted on the state return before being deducted at the federal level. Pass-through entities may see even more complexity, since the disallowed interest expense at the partnership level becomes a partner attribute for federal tax purposes and may be handled differently on the state return.
States may need to determine whether this attribute will apply on a pre- or post-apportioned basis.
Additional considerations arise with respect to the tax attribute limitations provided in sections 381 and 382. Not all states conform to section 381, e.g., New Jersey and Tennessee, or the regulations thereunder. Many state tax codes are silent with respect to the application of section 382, implying they adopt the federal annual limitation. Others like California and South Carolina modify this section for state tax attributes, e.g., NOL carryforwards.
The following states may generally conform to the section 163(j) business interest expense limitation due to the rolling conformity or related existing state guidance: Alabama, Alaska, Colorado, Connecticut, District of Columbia, Delaware, Illinois, Kansas, Louisiana, Massachusetts, Missouri, Montana, Nebraska, New Jersey, New Mexico, New York, North Dakota, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee and Utah.
States that follow a fixed date conformity will need to take action to conform to the IRC as of Dec. 22, 2017, or later, and therefore adopt section 163(j).
The following are examples of states’ guidance on conformity to section 163(j):
- Georgia – H.B. 918, signed into law March 2, 2018, provides that Georgia adopt the IRC as of Feb. 9, 2018, but will decouple from section 163(j).
- Idaho – H.B. 355, signed into law Feb. 9, 2018, provides that Idaho adopt the IRC as of Dec. 21, 2017, one day before the TCJA was signed, with certain exceptions pertaining to sections 965 and 213. In a subsequent legislation, H.B. 463, signed into law March 12, 2018, updated the state’s conformity to the TCJA as of Jan. 1, 2018, and lowered its corporate tax rate to 6.925 percent. Accordingly, Idaho should conform to the TCJA’s provisions relating to section 163(j).
- Virginia – H.B. 154, signed into law Feb. 23, 2018, provides that Virginia conform to the IRC as of Feb. 9, 2018, with exception to any provision of the TCJA that affects the computation of federal taxable income of corporations for taxable years beginning after Dec. 31, 2016, and before Jan. 1, 2018. As such, Virginia decouples from section 163(j) as it affects the computation of federal taxable income of corporations for tax years after Jan. 1, 2018.
- West Virginia – H.B. 4135, signed into law Feb. 21, 2018, provides that West Virginia conform to the IRC as of Dec. 31, 2017, including section 163(j).
- Wisconsin – Act 231 adopts the IRC as of Dec. 31, 2017, but specifically decouples from section 163(j).
Modification of NOL deductions pursuant to section 172
Whether a state decides to adopt the TCJA’s indefinite carryforward period, allow NOLs to offset only 80 percent of taxable income or disallow NOL carrybacks depends on the state’s conformity to the IRC. Currently, most states decouple from pre-TCJA NOL provisions. Thus, states’ legislative actions in the upcoming months will dictate whether NOL application and tracking will become even more complex post-TCJA when calculating state taxable income.
Many states decouple from section 172 by providing their own treatment for NOLs through limited carryforward periods (e.g., Arkansas, Illinois, Wisconsin), disallowance of carrybacks (e.g., Alabama, Connecticut) restrictions on use through filing methodologies (e.g., California, Montana) or caps based on the taxable income (e.g., Louisiana, Pennsylvania).
As noted, most states have not completed their 2018 legislative sessions, but the following observations can be made:
- Additional compliance burdens will be created since pre- and post-TCJA NOLs must be tracked and applied separately in conforming states. To efficiently use existing tax attributes and reduce risk, NOL calculations prior to Dec. 31, 2017, should be kept separate from those relating to NOL calculations under the TCJA.
- Inconsistencies between the federal and state rules may complicate income tax provisions. Consider whether adjustments to valuation allowances are needed to account for the change in the law.
- In merger-and-acquisition transactions, some may view pre-TCJA NOLs as more valuable than post-TCJA NOLs. However, any section 382 limitations still need to be taken into consideration.
- Tax planning and compliance issues may arise due to different starting points for the calculation of state income tax, i.e., Line 28 or Line 30 of the 1120. Further, novel difficulties are likely to be encountered due to varying state tax filing methodologies, such as separate company or mandatory combined reporting.
- New complexities should be expected in states that provide for their own NOL limitations that are completely separate from the governing IRC rules. For instance, in Pennsylvania, corporate taxpayers can only use a percentage of the NOLs to offset their taxable income (35 percent in 2018 and 40 percent in 2019 and thereafter). Unless addressed by the legislature, Pennsylvania taxpayers with post-TCJA NOLs are likely to experience limitation at both the federal and state level and pay at least some amount of income tax.
- States that use Line 30 of U.S. Form 1120 as the starting point of calculating their C-corporation state taxable income and do not add back the federal NOL are likely to see an increase in revenue.
The following are examples of some states’ guidance on how they will treat conformity to section 172:
- Illinois – The Illinois Department of Revenue published guidance discussing the impact of the TCJA on its state revenue. The IDOR noted that amended section 172(a) limiting the use of NOL deduction to 80 percent of taxable income may potentially increase Illinois base income and/or tax revenue.
- Virginia – H.B. 154, signed into law Feb. 23, 2018, provides that Virginia conform to the IRC as of Feb. 9, 2018, with exception to any provision of the TCJA that affects the computation of federal taxable income of corporations for taxable years beginning after Dec. 31, 2016, and before Jan. 1, 2018. As such, Virginia continues to decouple from section 172 as it affects the computation of federal taxable income of corporations for tax years beginning Jan. 1, 2018.
The state income and franchise tax environment is evolving rapidly in response to the TCJA. Some states are taking advantage of the new business tax revenue enhancers like the section 965 “repat” dividend provisions, NOL limitations and section 163(j) to boost their own tax collections. Others are leveraging off these to reduce their rates or are considering adopting the expanded federal cost recovery rules. We will continue to monitor state actions and inform you of them as they occur. In addition, we will roll out information on other key TCJA provisions as they affect states, such as the section 199A deduction and changes to the dividends-received deduction rules under section 243.
As states continue with their 2018 legislative sessions and announce conformity with or decoupling from the TCJA’s provisions, it is advisable to discuss the impact of state action on capital cost recovery with your state and local tax professional.
Please visit our Tax Reform Resource Center on our website for additional information.