The federal tax reform legislation enacted in 2017 created GILTI as a new inclusion in gross income.2 The legislation also created two new deductions from federal taxable income, a 50% GILTI deduction, and a FDII deduction.3 GILTI effectively imposes a minimum tax on profits from certain “intangible” income of a U.S. shareholder’s controlled foreign corporations (“CFCs”).4 The FDII deduction effectively creates an incentive for income from U.S.-held “intangibles” exploited off-shore.
For states that conform to the federal definition of taxable income, the GILTI inclusion is generally reflected in state taxable income. On this point, we have argued that Pennsylvania does not conform automatically to federal tax reform because automatic conformity would be an unlawful delegation of legislative power by Pennsylvania’s legislature to the federal Congress.5 The principles underlining that non-delegation theory were recently sustained by the Pennsylvania Commonwealth Court in Phantom Fireworks.6 Thus, the features of tax reform—like GILTI—may not be automatically included in Pennsylvania law.
Setting aside that issue, Pennsylvania’s Department of Revenue interprets Pennsylvania law as changing automatically as the Internal Revenue Code (“IRC”) changes. Under this view, GILTI is in the Pennsylvania tax base because GILTI is now included in federal taxable income. The question, then, is how to treat it. GILTI shares some similarities to subpart F income. For example, GILTI is included in the federal tax base of a shareholder of a CFC even if the CFC did not actually distribute a dividend. Yet despite any similarities, GILTI is an entirely new inclusion in federal gross income—GILTI is not technically “subpart F” income, nor is it technically a dividend because it is not distributed from earnings and profits.
Yet, despite the fact that GILTI is not, technically speaking, a dividend, the Department has, in Bulletin 2019-02, taken the position that it will allow the DRD with respect to the GILTI inclusion. This treatment is supported by Commonwealth v. Emhart.7 In that case, the Commonwealth took the position that a taxpayer cannot take a DRD for subpart F income. The Supreme Court of Pennsylvania disagreed, reasoning that income from a subsidiary that is included in its shareholder’s income should be allowed a DRD, and that a DRD could only apply with respect to subpart F income at the time it is included in the U.S. shareholder’s income. This is because previously taxed subpart F income is excluded from a U.S. shareholder’s federal and Pennsylvania taxable income when actually distributed.8 Like subpart F income, the only time the state DRD can apply to GILTI is at the time of its inclusion in income.9 Thus, the Department’s allowance of a DRD for GILTI is a reasonable interpretation of Emhart.
Pennsylvania Gets GILTI and FDII Deductions Wrong
Although the Bulletin is correct in concluding that GILTI, if it is included in income, should qualify for the DRD, the Bulletin is incorrect in concluding that taxpayers cannot claim the GILTI and FDII deductions. This is because Pennsylvania’s corporate income tax statute defines a corporation’s Pennsylvania taxable income as “taxable income” returned by the corporation to the federal government.10 Under the IRC, a corporation’s federal “taxable income” is its “gross income minus the deductions allowed by this chapter”.11 “This chapter” is Chapter 1 of the IRC, which includes all “special deductions”, like the GILTI and FDII deductions. As a result, both federal and Pennsylvania “taxable income” reflects the deductions for GILTI and FDII.
The Bulletin states that taxpayers cannot claim the GILTI or FDII deductions because they are special deductions. However, the fact that they are special deductions is not relevant in determining whether they are allowed in computing Pennsylvania taxable income. Pennsylvania conforms to the GILTI and FDII deductions because special deductions, like the GILTI and FDII deductions, are allowed in computing federal taxable income, and Pennsylvania conforms to federal taxable income.
In making its “special deductions” argument, the Department may be relying on a regulation promulgated in 1978 that defines “taxable income” as: “Federal taxable income before net operating loss deduction and special deductions []presently Line 28 . . . unless the context clearly indicates otherwise.”12 However, this regulation is now outdated. Before the addition of the GILTI and FDII deductions, the most significant items deducted on Federal Form 1120, Line 28 were the federal net operating loss and DRDs. Pennsylvania statute was consistent with the regulation before federal reform because it required a taxpayer to add back the federal net operating loss and limits its DRD only to the extent dividends are included in taxable income.13 Thus, the regulatory reference to Line 28 was just a shorthand way of describing the statutory scheme as it existed at the time the regulation was promulgated. But because GILTI and FDII are now special deductions that are not modified by Pennsylvania statute, the regulation’s reference to Line 28 is now obsolete.
In our view, corporate taxpayers should follow Pennsylvania’s statutory language and claim the GILTI and FDII deductions in computing Pennsylvania taxable income.
Claiming the FDII deduction is straight-forward, but claiming the GILTI deduction carries additional nuances. A mechanical application of the GILTI deduction may result in a greater total deduction than the taxpayer’s GILTI inclusion. For example, a taxpayer with a $100 GILTI inclusion and $50 GILTI deduction must decide whether Pennsylvania’s DRD applies to the full GILTI amount included in federal taxable income ($100), or the net amount after applying the 50% GILTI deduction ($50). Even if the Department concedes that taxpayers are entitled to the GILTI deduction, it would likely take the position that Pennsylvania’s DRD is limited to the net $50.14
What’s Next
The Department anticipates providing additional guidance. One question that remains unclear is how the DRD applies to a GILTI inclusion where all or part of the inclusion is attributable a less-than-80% owned CFC.15 Pennsylvania applies a reduced DRD (either 50% or 65%) to dividends from subsidiaries when ownership is less than 80%. Because a U.S. shareholder’s GILTI inclusion is calculated for federal purposes on an aggregate (rather than CFC-by-CFC) basis, the application of Pennsylvania’s DRD ownership requirement is uncertain when a U.S. shareholder’s GILTI inclusion is partly attributable less-than-80% CFCs. This may be addressed in future guidance.
- In any event, it is important to note that a Corporate Tax Bulletin is merely “revenue information.” 61 Pa. Code § 3.4. And the Department’s own regulation governing “revenue information” provides that “revenue information[] is issued for informational purposes only and should not be relied upon or used in tax appeals.” Thus, the Department’s position in a Tax Bulletin should not be viewed as having the force or effect of a regulation.
- P.L. 115-97 (Dec. 22, 2017); IRC § 951A.
- IRC § 250(a)(1)(B) (GILTI deduction); IRC § 250(a)(1)(A) (FDII deduction). The deductions may be reduced in certain circumstances.
- We use “intangible” income as a general reference to the GILTI and FDII calculations.
- Sollie, K. and Watt S., “Decouple Entirely: How Rolling IRC Conformity May Not be Rolling Conformity” (webinar published June 7, 2018).
- Phantom Fireworks Showrooms LLC v. Wolf, 2018 Pa. Commw. Lexis 698 (Dec. 8, 2018) (prohibiting delegation to a body other than the state legislature).
- 443 Pa. 397 (1971).
- IRC § 959.
- IRC § 951A(f)(1)(A).
- 72 P.S. § 7401(3)1.(a)
- IRC § 63.
- 61 Pa. Code § 153.11 (internal quotations omitted).
- 72 P.S. § 7401(3)1.(b), (m).
- See 72 P.S. § 7401(3)1.(b) (DRD applies “only to the extent that such dividends are included in taxable income”).
- 72 P.S. § 7401(3)1.(b) (DRD applies to “the extent such dividends would be deductible in arriving at Federal taxable income if received from a domestic corporation.”); see IRC § 243.
Client Alert 2019-018
