Response to Federal Tax Reform

• Tax on repatriated earnings.  The TCJA provides for a one-time tax under I.R.C. § 965 on undistributed post-1986 earnings of foreign subsidiaries owned by U.S. corporations.  These deemed dividends are treated as Subpart F income, and thus, are included in the taxpayer’s Line 28 taxable income.  Under the current CBT statute,¹ a taxpayer is entitled to a 100% dividends received deduction for actual or deemed dividends from an 80%-or-more owned subsidiary.  Under current New Jersey law, therefore, earnings of an 80%-or-more owned foreign subsidiary that are deemed to be repatriated under I.R.C. § 965 would not be subject to CBT. The proposed legislation would change this by enacting a one-time 9% levy on any dividends included in the taxpayer’s federal Line 28 taxable income.² The proposal includes a provision that prohibits taxpayers from deducting the one-time levy in computing their entire net income for CBT purposes.
  
  The levy applies not only to deemed dividends under I.R.C. § 965 but to any dividend received in the 2017 tax year.  (It is necessary to apply the levy to all dividends to avoid a foreign commerce clause issue under Kraft.³). The levy is computed by apportioning a taxpayer’s total dividends received to New Jersey using a standard “allocation factor” of roughly 3% (which reflects the ratio of New Jersey’s gross domestic product to the total U.S. gross domestic product).⁴ 

This standard allocation factor may violate external consistency or otherwise be distortive for out-of-state taxpayers.

• Applying the interest deduction limitation. Under I.R.C. § 163(j), as amended by the TCJA, the deduction for business interest is limited to the sum of the taxpayer’s: (i) business interest income; (ii) 30% of adjusted taxable income; and (iii) floor plan financing interest.  S2746 provides that this limitation shall apply in computing entire net income for CBT purposes.

The proposed legislation further provides that the interest limitation must be applied on a “pro-rata basis to interest paid to both related and unrelated parties.”⁵  But the bill does not specifically explain how a taxpayer should compute the limitation if it reports its federal income tax as part of a consolidated group. In Notice 2018–28, the IRS stated that it intends to apply the business interest limitation rules at the level of the consolidated group.  As a result, for purposes of the limitation, a consolidated group’s taxable income will be its consolidated taxable income and intercompany obligations will be disregarded.  Recently, the New Jersey appellate court held that federal consolidated return principles apply to the CBT even though it is computed on a separate-company basis.⁶ For CBT purposes, therefore, taxpayers may be able to take the position that the interest limitation should be computed on a consolidated basis rather than a separate-company basis.  

Other Proposed Amendments

• Surtax for taxpayers with entire net income greater than $1 million.  The proposed legislation includes a two-year surtax on corporate taxpayers with entire net income that exceeds $1 million.⁷ The surtax tax is 1.5% for taxpayers with entire net income in excess of $1 million; the surtax jumps to 4% for taxpayers with entire net income in excess of $25 million.⁸ The maximum combined corporate tax rate, therefore, is 13%, which would be the highest in the nation.
• Dividends Received Deduction limited.  The bill reduces the dividends received deduction for dividends from 80%-or-more subsidiaries from 100% to 95%.⁹ New Jersey has very taxpayer-friendly case law, however, on the scope of the unitary business principle.  So, despite the proposed legislation, taxpayers may be able to take the position that their dividends are nonunitary and thus excludable from the CBT tax base entirely
• Taxation of worldwide income.  The New Jersey Tax Court, in Infosys Limited of India Inc. v. Director, Division of Taxation,¹⁰ ruled that a foreign corporation was not subject to CBT on its income unless it was included on Line 29 of its federal Form 1120–F.  In other words, a foreign corporation is not subject to New Jersey CBT on its foreign-source income or income that is immune from federal income tax based on a treaty.  The Tax Court’s decision is not yet final and is likely to be appealed.  In the meantime, the proposed legislation would effectively overrule the Tax Court’s decision and subject foreign-source income to taxation. Specifically, the proposed legislation broadens the definition of “entire net income” and makes any exclusions, exemptions, or deductions contained in a U.S. tax treaty inapplicable unless the treaty expressly applies to state taxes.¹¹
• Expanded addback for related-party interest and royalties.  Under the current CBT Act, interest and royalties paid to affiliates does not have to be added back if the affiliate is located in a foreign country with a tax treaty with the United States.¹² S2746 effectively repeals this so-called “treaty exemption” by limiting it to treaties that contain an express exemption from U.S. state income tax.¹³  

If you have questions about S2746, please contact one of the authors of this alert, or the Reed Smith attorney with whom you usually work.

1. See N.J.S.A. 54:10A–4(k)(5).
2. See S2746, § 3.b.
3. See Kraft General Foods, Inc. v. Iowa Dept. of Rev. and Fin., 505 U.S. 71, 79 (1992) (stating that “the Foreign Commerce Clause recognizes that discriminatory treatment of foreign commerce may create problems”).  Central to a Foreign Commerce Clause analysis is whether a state discriminates against foreign commerce in favor of domestic commerce.
4. See S2746, § 3.d. 
5. See id. at § 4.4(k)(2)(K).
6. See MCI Communication Servs., Inc. v. Director, Division of Taxation, 2015 WL 4537743 (N.J. Tax July 20, 2015), aff’d Slip Op., Docket No. A–5735–14T3 (N.J. Super. Ct. App. Div. June 15, 2018).  See our coverage of that case here.
7. See S2746, § 1.(1)–(2).
8. See id. at § 1.(1)–(2).
9. See S2746, § 4.4(k)(5)(B).
10. See Infosys Limited of India Inc. v. Director, Division of Taxation, 2017 WL 5907704 (Nov. 28, 2017), aff’d on reconsideration, 2018 WL 1385844 (N.J. Tax March 19, 2018).  For our previous coverage of Infosys, see our alerts, here and here.
11. See S2746, § 4.4(k)(16); see also id. at § 4.4(k)(2)(A).
12. N.J.S.A. 54:10A–4(k)(2)(I).
13. See S2746, § 4.4(k)(2)(I).

Client Alert 2018-140