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Lawyer Asks U.S. Treasury for American Rescue Plan Act 'Claw-Back' Guidance

Dated Mar. 25, 2021

SUMMARY BY TAX ANALYSTS

Stephen Kranz, a partner at McDermott Will & Emery, has written a letter to U.S. Treasury Secretary Janet Yellen, asking Treasury to promptly issue guidance regarding the state relief "claw-back provision" included in the recently enacted American Rescue Plan Act of 2021 (P.L. 117-2), arguing that the provision requiring the return of federal relief funds if the funds are used to finance state tax reductions is ambiguous and that states are rightfully concerned about its potential effect on state tax policy.

March 24, 2021

Hon. Janet L. Yellen
Secretary
U.S. Department of the Treasury
1500 Pennsylvania Ave., NW
Washington, DC 20220

Re: Request for Guidance on the American Rescue Plan Act
State Relief Funds Claw-Back Provision

Dear Secretary Yellen:

I write to ask that your office, as expeditiously as possible, provide public guidance interpreting the claw-back provision in the recently enacted American Rescue Plan Act of 2021 (ARPA). ARPA includes a provision requiring that a state return relief funds to the federal government if the state uses the relief funds to finance tax reductions. This provision brought the world of state and local tax policymaking to a grinding halt and causes irreversible damage as each day passes.

ARPA's recent adoption occurred during the final of weeks of many states' legislative sessions. Legislatures, Governors, and tax administrators across the country are suddenly in an uncertain world where every tax change or adjustment being considered, no matter how innocuous or routine, carries the risk of a reduction to their state's share of federal relief funding. If the Treasury Department interprets ARPA's plain language broadly or fails to provide sufficient guidance, sub-national policymakers will live with this risk for the next three years. That is untenable. This claw-back provision is the least understood and most discussed provision of the six hundred page ARPA, which expressly gives the US Treasury the authority to provide guidance interpreting the language. Because many sessions are ending soon, rapid issuance of guidance is needed by state legislatures before they adjourn.

The claw-back provision states:

A State or territory shall not use the funds provided under this section or transferred pursuant to section 603(c)(4) to either directly or indirectly offset a reduction in the net tax revenue of such State or territory resulting from a change in law, regulation or administrative interpretation during the covered period that reduces any tax (by providing for a reduction in a rate, a rebate, a deduction, a credit or otherwise) or delays the imposition of any tax or tax increase.

This provision is ambiguous and states rightfully are concerned about its impact. Among other issues, this provision is unclear as to (i) what would be considered an “indirect” reduction and (ii) how “net revenue” is calculated and over what time period. We encourage the US Treasury to issue guidance that avoids the provision hamstringing state and local governments from the normal ebb and flow of tax policy changes, adjustments and interpretations. As mentioned above, state legislatures came to a grinding halt fearing the claw-back provision might jeopardize their states' receipt of recovery funds. We expect that the provision also will constrain state tax departments in their issuance of routine guidance. They, too, will fear such guidance could be construed as a tax cut causing their states to lose federal relief funds. We cannot stress enough the significance of these fears; they are very real. This provision already is having dramatic effects on the power of states over their tax policy — we have seen legislation that was in the works long before ARPA and addresses issues unrelated to revenue reduction, but with a potential revenue reduction effect, lose support solely because of the ARPA uncertainties.

Congress obviously wanted to avoid funding state tax cuts when it adopted this provision but it is unlikely Congress intended the complete preemption of state tax policy. There are a numerous legislative and administrative actions that should not be covered by the provision, including, but not limited to:

  • Changes addressing state conformity to the Internal Revenue Code (IRC)

  • Corrections of unconstitutional tax statutes or rules,

  • Corrections of tax provisions barred by or that violate federal law,

  • Actions in which there is no or only a weak connection between the law change reducing net revenue and the use of federal relief funds,

  • Changes in the law announced prior to the enactment of ARPA and

  • Reductions in net revenue related to purposes that further ARPA's objectives.

Treasury guidance should give a balanced interpretation to the claw-back provision, considering each of these unintended situations, in a manner that avoids an open-ended reading of the statute, and consistent with Congress's clear intent.

State Conformity to the IRC

Most states use federal income as the starting point for computing the state income tax bases and most state tax laws are based, in part, on the IRC. Some state laws automatically conform to the current IRC while others conform to the IRC as of a specific date and legislatively update the conformity date from time-to-time. States conform to select provisions of the IRC by coupling and decoupling from certain federal provisions. For example, most states do not allow federal bonus depreciation and, thus, decouple from that provision. Conformity is designed for simplicity of audits and compliance and selective coupling and decoupling is designed to effectuate state tax policy.

State legislatures are concerned that both the routine updating of state conformity to IRC tax cuts and any decoupling from federal base broadening provisions might trigger the claw-back provision. First, many states may want to (and because their tax code is coupled to the IRC may automatically) include federal tax reductions aimed at the economic disruption caused by Covid 19. For example, many states are proceeding to update their tax statutes in the wake of the recently enacted CARES Act. Yet the claw-back provision may prevent this, unnecessarily diluting the federal tax policy initiative. Second, some states are still catching up to the once-in-a-generation changes in the IRC over the past 4 years. Some of these changes broadened the federal income tax base, resulting in unintended state tax increases. A state's decoupling from such a federal base broadening provision is not a state tax decrease, it is an action to prevent an unintended state tax increase; these are two very different things.

There is no indication that Congress intended for the claw-back provision to apply to state actions that adopt federal tax reductions or prevent state tax increases caused by changes in federal law. Thus, the US Treasury should interpret the ARPA's claw-back provision as inapplicable to state actions that conform to or decouple from changes to the IRC.

Repealing Unconstitutional Taxes

Often, as the result of judicial interpretation, more recent advice from their attorney general or effective advocacy by taxpayers, state legislatures and administrators determine that one of their tax statutes or regulations violates some provision of the U.S. or the state's Constitution. Now, state policy makers are afraid to change or strike unconstitutional tax provisions (something they must do to preserve the integrity of their tax regimes) because they are concerned that such actions could result in a tax decrease, triggering the claw-back. They are even afraid to delay the imposition of a previously adopted, potentially unconstitutional tax even though the delay is solely to vet the constitutionality of the tax. This is not speculation; we have watched this problem occur since ARPA was adopted.

Guidance from the US Treasury adopting a balanced interpretation of ARPA's claw-back provision will ease concerns and allow states to take actions that ensure their laws are constitutional. There is ample rational for such an interpretation. The claw-back is triggered only if the action results in “a reduction in the net tax revenue of the state.” If a tax is unconstitutional, the state is not permitted to impose the tax and, thus, the state is not entitled to the revenue from the unconstitutional tax. Repealing or changing an unconstitutional tax should not result in a reduction of net tax revenue to the state because the state never had the right to the revenue. States urgently need guidance confirming the APRA claw-back provision does not operate in this manner.

Avoiding Violations of Federal Law

While the federal government generally does not interfere with state tax policy, there are provisions of federal law that constrain state tax policy in specific areas. For example, the Internet Tax Freedom Act (ITFA) is a federal law that prohibits states from imposing discriminatory taxes on electronic commerce. This is a developing body of law because of advances in technology and business models and, as expected, states routinely change laws or administrative positions to ensure their taxes do not run afoul of ITFA. There is risk these changes will trigger the claw-back if they result in a tax decrease. To clearly state the absurdity of this, states may be reluctant to remedy a violation of one federal law, in fear of “violating” another federal law (i.e., triggering the claw-back). This is but one example.

The same analysis applicable to unconstitutional state tax laws should apply to state tax laws that violate a federal law. Thus, the US Treasury should issue guidance stating that the claw-back provision is inapplicable to any state action that cures a conflict with another federal law.

No Connection to Federal Recovery Funds

The claw-back provision requires that there be some connection, either direct or indirect, between the receipt of federal recovery funds and the change in state tax law that reduces net revenues. Many states receiving recovery funds under the ARPA either have or are projected to have budget surpluses. It is doubtful the connection to recovery funds required by the claw-back provision exists with respect to state tax law changes that reduce an existing or projected budget surplus. The claw-back provision should apply to states with existing or projected budget surpluses only after the revenue decrease caused by tax law change exceeds such surplus and only to the extent thereof. Treasury guidance should interpret the claw-back provision as only applying to states that either have or are projected to have budget deficits where the tax law change would increase the deficit.

Previously Announced Law Changes

The purpose of the claw-back provision is the prevention of state use of federal relief funds to finance state tax cuts. Many states had announced prospective law changes that would reduce net revenue prior to the publication of the claw-back provision on March 12, 2021. Examples of such prospective law changes include tax bills moving through the legislatures or rules and regulations moving through states' administrative procedures. We believe any guidance published by the Treasury Department should include a safe harbor for cases where the change in the law was announced before enactment of ARPA. Such a safe harbor should include bills reported out of committee or passed by one chamber of the legislature. Such a safe harbor also should include cases where a tax administrator has issued a notice of proposed rulemaking on guidance interpreting a previously enacted tax decrease. There may be other facts and circumstances that fit into this category where the legislative process gave the tax administrator insufficient time to implement a new tax increase and the tax law change would extend the effective date of the new tax.

Tax Law Changes that Further ARPA's Objectives

ARPA's overarching purpose is economic stimulus. Many of the provisions providing financial assistance to business, workers, families and the like could result in the receipt of income taxable at the state level. Any attempt by a state to ameliorate the state tax impact of such payments could trigger the claw-back provision. The same is true of state tax incentives provided to business for the purposes of hiring, training or retraining new or existing employees. Such tax incentives would trigger the claw-back provision. Also, any new, or the extension of existing, state tax incentives for so-called “green energy” are frozen for three years by the claw-back provision. Any Treasury Department guidance interpreting the provision should include facts and circumstances based exceptions or safe harbors for state tax decreases that further the objectives of the ARPA.

* * *

The APRA claw-back provision casts a pall on the state tax policy world, and rightfully so. We urge the issuance of guidance by the Treasury Department as soon as possible reflecting, among other things, the suggestions provided herein. Such guidance will alleviate the concerns of state governments and allow state policymakers to function and continue to administer state taxes. We recommend that this guidance include specific safe-harbors for states that allow the normal tax policy to continue to function. Absent guidance, state tax administration will remain frozen for the next three years. States will feel forced to impose illegal and illogical taxes, which will cause unnecessary and costly litigation for states and taxpayers, both of which are already in economically precarious situations.

We welcome the opportunity to discuss with you further these and other concerns. I can be reached at skranz@mwe.com or (202) 904-7829 with any questions or requests for additional information.

Respectfully submitted,

Stephen P. Kranz
Partner
McDermott Will & Emery
Washington, DC

cc:
Mark Mazur
Acting Assistant Secretary of the Treasury for Tax Policy

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