State corporate income taxes are generally based on federal corporate income tax concepts. As a consequence, when Congress enacts significant changes to the Internal Revenue Code (‘‘IRC’’), the effects will typically impact both federal and state corporate income taxes. It is somewhat surprising, then, that state legislatures are only just beginning to react to the most significant change to the federal corporate tax law in 30 years. As of this writing, only a few state legislatures have taken action to amend state tax statutes since December 22, 2017 when the TCJA was signed into law.
To some degree, this delayed reaction by state legislatures is understandable. After all, state legislative sessions are just getting underway in most states. Moreover, many states may be assuming that time is not of the essence. The majority of the changes brought about by the TCJA take effect for tax years beginning in 2018, which may lead some states to believe a swift legislative response is not necessary. However, the complacency by some state legislatures may be misplaced, because the most significant change in the TCJA (at least for most multinational corporations) impacts the 2017 tax year: the deemed repatriation of foreign income, colloquially referred to as the ‘‘toll charge’’ or ‘‘transition tax.’’ The 2017 effective date places state legislatures in an unusual position—determining how existing law interacts with a new federal law, applied retroactively to a prior tax year.
This article seeks to better explain the impact of the deemed repatriation on existing state tax laws. Given the relative silence from most states on this topic, this is inherently an analytical exercise; and this exercise begins with the assumption that states will not retroactively change their laws to treat the deemed repatriation in a fundamentally different way than their laws—as they exist today—should treat this foreign source income. That being said, this assumption is not needed in all states. Some states (New York, for example) have publicly stated how the deemed repatriation interacts with existing law. Accordingly, and to the extent possible, this article uses states’ initial reactions to the deemed repatriation to first assess whether taxpayers can anticipate a windfall from the deemed repatriation for state tax purposes. And second, to caution that current predictions regarding the consequences of the deemed repatriation may be tentative. Taxpayers should pay close attention to the looming state legislative sessions.
Whatever the outcome of our analysis in a particular state, our goal is that after reading this article, the need for state taxpayers with foreign operations to carefully consider the state tax impact of the deemed repatriation will become clear. This includes considering the impact of any future planned actual distributions to U.S. companies or shareholders, as well as the potential corollary impact on state tax haven legislation. Given the magnitude of foreign earnings held by U.S. corporations, states may see the deemed repatriation as a potential opportunity to shore-up their annual budgets.
Mechanics of the Deemed Repatriation under IRC §965
To understand the state impact of the deemed repatriation, we must first begin by describing the mechanics of the deemed repatriation at the federal level. The TCJA imposes a one-time tax on the undistributed post-1986 earnings of certain foreign subsidiaries owned by a U.S. corporation. Under IRC §965(a), a U.S. corporation includes the deemed repatriation in gross income by increasing its subpart F income by the amount of earnings and profits of its controlled foreign corporations (allowing offsetting for earnings deficits) as of November 2, or December 31, 2017 (whichever is greater). But the entire amount of the deemed repatriation is not included in federal taxable income. Congress determined that subjecting all of the post-1986 undistributed earnings of certain foreign subsidiaries of U.S. corporations to federal income tax at 35% would not have been politically viable. Accordingly, the TCJA introduced a new deduction under IRC §965(c). This provision allows for a deduction from gross income so that the amount of the deemed repatriation, net of the deduction, will be taxed an effective rate of 8% (or 15.5% for foreign earnings held in cash or cash-equivalents). Taxpayers can elect to pay the resulting federal tax over eight years. To demonstrate how the deemed repatriation functions, consider the following example:
Taxpayer A includes $100 of foreign earnings of a foreign subsidiary held as cash in its gross income as subpart F income under IRC §965(a). Under IRC §965(c), Taxpayer A would also be entitled to deduct $55.70 from gross income. This is because after applying the 35% corporate tax rate to the net deemed repatriation of $44.30 would result in $15.50 of tax – resulting in a net effective tax rate of 15.5% ($100 - $55.70 = $44.30; $44.30 x .35 = $15.50).
But how will state corporate income tax laws interact with the TCJA’s deemed repatriation provisions?
Applying IRC §965 under Current State Law
The answer to this question presents our first analytical inquiry: how do states conform to the IRC? At the risk of oversimplifying a complicated question, we place states in one of two categories: static conformity or rolling conformity. Static conformity states—or states that conform to the IRC as it existed on a specific date in time—will require legislative action to include the deemed repatriation under IRC §965 in the tax base for state income tax purposes. To narrow our focus, we assume that states with static conformity will not update their IRC conformity date to incorporate the IRC §965 deemed repatriation in their tax base.
Our focus, then, is on the rolling conformity states. These states conform to IRC as it exists for a given tax year. As a general matter, these states’ corporate tax regimes generally begin with federal taxable income, then modify that figure by adding or subtracting specific items of income from the federal tax base to reflect the state’s policy preferences. Because the TCJA’s deemed repatriation applies to tax years beginning before 2018, taxpayers must apply pre-TCJA state law to determine the impact of the federal changes, with the unfortunate caveat that such rules may ultimately be changed retroactively. Accordingly, most rolling conformity states will include the net amount of the IRC §965 deemed repatriation—$44.30 in our example above—in their tax base, before applying state additions and subtractions.
In most rolling conformity states, state subtraction modifications under existing law will eliminate all or a substantial part of the deemed repatriation. This is because the IRC §965(a) inclusion is treated as subpart F: IRC §965(a) states that subpart F income determined under IRC §952 (which is included in gross income under IRC §951(a)(1)) is increased by the amount determined under IRC §965(a). Most states provide at least some subtraction for subpart F income specifically, or effectively exclude subpart F income as a dividend received deduction. But in some states, existing law would permit taxpayers to subtract the gross amount of the IRC §965 deemed repatriation, before application of the IRC §965(c) deduction. Extending our example to this permutation, consider the following hypothetical:
Taxpayer A is subject to tax in Pennsylvania, a rolling conformity state. Pennsylvania determines a taxpayer’s state tax liability by beginning with federal taxable income. Pennsylvania also allows taxpayers to subtract Pennsylvania dividends received from federal taxable income. It is settled law that Pennsylvania treats subpart F income as a dividend for the purposes of that subtraction. To compute its tax liability in Pennsylvania, Taxpayer A would include the net IRC §965 amount of $44.30 in federal taxable income.
With the starting point for taxable income resolved, how should Taxpayer A compute its dividend received deduction? Taxpayer A has two options. First, Taxpayer A could subtract $44.30, the net IRC 965(a) amount that was included when determining Pennsylvania’s starting point. This choice places Taxpayer A in a ‘‘neutral’’ position—it is no better off or burdened from a state tax perspective as a result of the deemed repatriation.
But Taxpayer A may take a different route. Rather than remaining in a ‘‘neutral’’ position, Taxpayer A can move into a beneficial position by applying the dividend received deduction to the entire $100 deemed repatriation. After all, in Taxpayer A’s situation, IRC §965(a) requires the inclusion of the full $100 deemed repatriation in gross income because it is a dividend. Separately, IRC §965(c) requires a $55.70 deduction. As a result, Taxpayer A would get a benefit in Pennsylvania of $55.70 ($44.30 - $100 = -$55.70).
This outcome will vary by state, generally depending on whether the state would consider this a prohibited double-deduction (Illinois, for example, has such a prohibition). States are likely to react with legislation or administrative guidance to prevent this potential double-benefit, and in doing so, may at the same time toy with expanding the state tax imposed on the deemed repatriation.
Moving From Hypothetical to Practical: State Guidance
Practitioners may be wary of the double deduction interpretation suggested above. Although this may be the correct reading from a technical perspective, will states respect the application of the statutory subtraction modification? To answer this question, we now turn to the limited state guidance on the deemed repatriation. We pause briefly to again emphasize one important caveat: state tax laws can change. Given the limited time states have had to react to the TCJA, we can expect that some changes may apply retroactively. As legislative sessions have only just begun, few states have had the opportunity to address this issue. But the states that have may shed light on what may come in
New York. New York’s Department of Taxation and Finance recognized that there may be uncertainty as to whether the deemed repatriation was ‘‘exempt CFC income’’ excluded from New York taxable income, and sought to provide certainty. The Department also recognized that although taxpayers could likely exclude the deemed repatriation as exempt CFC income, they may nonetheless be able to claim the IRC §965(c) deduction as well. As a result, the New York governor’s proposed draft budget legislation would clarify that the IRC §965(a) deemed repatriation amount is ‘‘exempt CFC income,’’ and taxpayers must add back the federal IRC §965(c) deduction, in determining New York taxable income. The draft legislation would have the effect of eliminating the possibility of a ‘‘double deduction,’’ while providing certainty that the net deemed repatriation would be excluded from the New York income tax base.
Idaho. While New York’s legislation clarified that New York taxpayers are not subject to the deemed repatriation and addressed the excess deduction issue, other states may broaden the amount of the deemed repatriation subject to tax. For example, Idaho has enacted legislation that requires taxpayers to add back the IRC §965(c) deduction. But because the state provides for 80% (or 85% in some cases) subtraction modification for subpart F income, Idaho will effectively tax 20% of the IRC §965(a) deemed repatriation, before application of the deduction. Without the legislative change, Idaho may have only taxed 20% of the net amount of the deemed repatriation. Will other states follow suit?
Connecticut. Connecticut’s corporate income tax provides for a 100% dividends received deduction. But the state also disallows deductions for any expenses related to the production of dividend income. Current law does not provide for a mechanism to calculate expenses related to dividends. Draft legislation released in February would use the expense disallowance provision to effectively tax a portion of the deemed repatriation. The legislation provides that ‘‘expenses related to dividends shall equal ten per cent of all dividends received by a company during an income year.’’ As a result, some Connecticut taxpayers may be effectively subject to tax on 10% of the IRC §965(a) amount. Will other states that currently provide for a full subtraction for the deemed repatriation effectively tax a portion of the repatriation by disallowing deductions for related expenses?
Massachusetts. Massachusetts law currently allows a 95% dividends received deduction. This deduction applies to subpart F income, as well as actual dividends received. In producing its estimate of the tax revenue associated with the TCJA deemed repatriation, the Massachusetts Department of Revenue calculated that taxing 5% of the deemed repatriation for all Massachusetts taxpayers would result in approximately $65 million of additional state revenue. But in producing this estimate, the Department also determined what the revenue impact would be if the state were to reduce its dividends received deduction to various percentages less than 95%. These estimates are a reminder to taxpayers and practitioners that some state legislatures may find it hard to resist capturing some of the excess revenue that could be generated by taxing a greater portion of the deemed repatriation than would be allowed under current law.
When ‘‘Deemed’’ Becomes ‘‘Actual’’: Implications of the Subsequent Actual Distributions
To this point, we have only discussed the state tax treatment of the TCJA deemed repatriation. However, once the post-1986 undistributed earnings of a foreign subsidiary has been subjected to tax under the deemed repatriation provision, the U.S. shareholder may cause the subsidiary to distribute that previously taxed income. How will states treat the subsequent distribution to a U.S. shareholder? Again, we begin by analyzing the federal treatment of the distribution. For federal purposes, post-1986 undistributed earnings will become ‘‘previously taxed income’’ under IRC §959 and, as a consequence, they will generally be excluded from federal gross income when distributed. However, this treatment may not be followed by all states. Consider the following:
New Jersey conforms to the IRC on a rolling basis, and conforms to federal taxable income without exclusion or deduction for dividends. New Jersey provides some dividends received deduction for dividends from 50%-or-greater-owned subsidiaries. Taxpayer A owns 49% of CFC 1. Taxpayer A included a $100 IRC §965(a) amount in its federal taxable income in 2017, representing the post-1986 undistributed earnings of CFC 1, and at the same time claimed a deduction under IRC §965(c) of $56.70. As a consequence Taxpayer A paid federal and New Jersey tax on a net IRC §965 amount with respect to CFC 1 of $44.30. In 2019, CFC 1 distributes $100 of income to Taxpayer A.
For federal tax purposes, the $100 distribution is excluded from gross income under IRC §959 because it was previously taxed income. But Taxpayer A must include the $100 in New Jersey taxable income for 2019, because the state conforms to federal taxable income before any exclusion for dividends, and Taxpayer A’s ownership of CFC 1 did not satisfy New Jersey’s requirement for receipt of a dividends received deduction. There is uncertainty as to how states will apply IRC §959, and there could be a significant state tax cost when repatriating earnings. This is especially true in states that do not provide for a full subtraction modification for dividends, or require that the corporation receiving the dividend satisfy certain ownership requirements with respect to the corporation paying the dividend.
California is an example of a state that does not conform to IRC §959 and, thus, does not follow the federal exclusion for income that has already been taxed under subpart F. As a result, water’s edge taxpayers may be required to pay California corporate tax on the portion of any future distributions not covered by California’s dividends received deduction, notwithstanding the fact that such distributions would be fully excluded from federal gross income.
What About State Tax Haven Laws?
The impact of the deemed repatriation on a corporation’s overall effective tax rate may go beyond deemed and actual repatriation of earnings. The interaction between the deemed repatriation and ‘‘tax haven’’ legislation in states such as Connecticut and Oregon is unclear. If the inclusion is required with respect to undistributed earnings of a foreign subsidiary that have previously been included in the taxable income of the water’s edge group for state purposes because the subsidiary is organized in a ‘‘tax haven’’ jurisdiction, will the inclusion be treated as if it were an actual dividend from a member of the water’s edge group and eliminated?
Also, with the adoption of the GILTI inclusion under IRC §951A, the ability of U.S. corporations to defer U.S. taxation of the earnings of their foreign subsidiaries will be severely limited going forward. With this in mind, it may no longer make sense for states that conform to the current IRC to retain their tax haven provisions. There seems to be little point in including subsidiaries organized in ‘‘tax haven’’ jurisdictions in the water’s edge group, if their earnings will be included in group income in the form of GILTI in any event. Thus, federal tax reform may have the unintended side effect of bringing to a close the states’ short, and arguably unconstitutional, foray into ‘‘tax haven’’ legislation. Legislation that would repeal its tax haven provisions and allow a state tax credit for tax already paid under the state tax haven regime has already been passed by the Oregon Senate, and is currently before the Oregon House.
Unfortunately, state tax issues are often an afterthought when analyzing the impact of federal tax legislation—particularly in the wake of sweeping federal tax reform. But state tax issues will have greater relative importance in determining a corporation’s effective tax rate as a result of the reduction of the federal corporate tax rate to 21% under the TCJA. Taxpayers should not ignore the potential state income tax benefits and costs associated with the TCJA deemed repatriation, as well as any future distributions for previously taxed foreign earnings in the future, and build these costs into their estimates today. Waiting for the dust to settle, while always a risky endeavor, may prove even riskier today.