Law professor Darien Shanske is proposing that California conform to global intangible low-taxed income and require taxpayers to pay whichever is higher — the liability based on GILTI conformity or under the state’s current system.
The proposal is notable not only because Shanske, a law professor at the University of California, Davis, is known nationally in the field, but also because his work is followed in nearby Sacramento by those buried in tax policy at the state capitol and is popular among California’s left.
In email to Tax Notes, Shanske said he has no insight into what California might do regarding the GILTI provisions of the federal Tax Cuts and Jobs Act.
However, he said there is an added layer of complexity when it comes to considering California’s approach to GILTI, because the state “has had a proto-GILTI provision since 1986.” Even when a taxpayer makes a water’s-edge election, a portion of controlled foreign corporation income is included in California’s tax base in proportion to the CFC's subpart F income.
“It is hard to say a priori which approach is better” — California’s current subpart F inclusion or conformity to GILTI, Shanske said. He added that there would be complexity in trying to layer GILTI inclusion on top of the state’s existing system.
“I therefore propose that California retain the current rule and conform to GILTI, but require a taxpayer to include only the higher result,” Shanske said. He added that he doesn’t believe there is a legal obstacle if done carefully.
Shanske described his proposal in more detail in a December 27 online post titled, “California Should Conform to GILTI, But in Its Own Special Way.”
In the piece, Shanske said California “pioneered taxing multinational corporations on the basis of their worldwide income,” and the U.S. Supreme Court upheld the state’s mandatory worldwide combined reporting regime in Container Corp. v. Franchise Tax Board. In response to pressure from the Reagan administration and international trading partners, the state provided a water’s-edge election.
“California did not give up in trying to tax income shifted out of the domestic tax base entirely however,” Shanske wrote. He described the state’s ultimate approach, saying it involves piggybacking on the federal subpart F regime, but rather than taxing subpart F income directly, “California includes the income of a foreign subsidiary in the same proportion as that subsidiary produces subpart F income.”
Regarding the constitutionality of his proposal, Shanske wrote, “Subpart F and GILTI are calculated at the federal level — whichever calculation is highest at the federal level will flow down to the states. So long as each state applies an internally consistent apportionment formula to the result of that calculation, then, if all the formulas are the same the result will be taxing 100 percent of suspect income at the state level.”
California 2019
California conforms to the IRC by a specified date, which right now is generally January 1, 2015. The state’s water’s-edge provisions are a special exception subject to rolling conformity — but the FTB explained in its preliminary report on specific provisions of the TCJA that for conformity to be automatic, California law must refer to the relevant IRC provisions. California’s water’s-edge provisions do not incorporate by reference IRC section 951A imposing GILTI; section 245 addressing the foreign dividends received deduction (DRD); or section 965 creating the repatriation provisions.
In a May news analysis of GILTI state tax issues, Tax Notes contributing editor Lee Sheppard touched on the fact that California’s water’s-edge election excludes income of foreign corporations but not CFCs. “It is not a given that California business taxpayers elect water’s edge; some want to import foreign losses,” she wrote. “If a taxpayer chose to remain in the worldwide system, GILTI is in the base and intragroup dividends are ignored. Termination of an election is at the taxpayer’s discretion, but the election in or out lasts seven years.”
Also, based on the FTB’s preliminary report, Sheppard wrote that state analysts “believe that the TCJA will cause water’s-edge businesses to pay more inbound dividends, which will be apportioned to the California base to the extent included after the DRD is applied.”
Both the Council On State Taxation and the State Taxes After Reform (STAR) Partnership — a coalition of companies and industry trade organizations addressing state business tax issues raised by the TCJA — are on top of the issue, arguing on behalf of large multistate businesses that California should not include any portion of GILTI in the state base.
The STAR Partnership argues that California already includes a portion of CFC income in computing the taxable income of a water’s-edge group, and that the state’s taxation of subpart F income is fundamentally different from taxing a portion of the operating income of foreign subsidiaries. COST, meanwhile, argues that the state might first need to repeal its existing approach before it could conform to GILTI.
COST also recently wrote a letter to the FTB referring to a meeting one month earlier where the FTB provided information on the TCJA’s GILTI provisions and indicated that it does not intend to sponsor conformity legislation during the 2019 legislative session.
The FTB forwarded a statement to Tax Notes clarifying that its decision not to sponsor conformity legislation does not suggest it has taken a position on GILTI inclusion or exclusion. “In the past, neither has FTB staff proposed nor the Board itself been the originator of federal conformity legislation relating to substantive federal provisions,” the statement said.
“Following in that vein, the FTB’s three-member Board has yet to take a position on conformity to the TCJA in general or in part and, to date no legislation on conformity has been introduced in the Legislature,” the statement continued. “The Board could engage in a support/no support manner if staff brought a bill for a position, which has not occurred. The three-member Board also traditionally works on conformity with the Legislature including, as it relates to revenue impacts, with the Administration.”
Additional factors that could influence California’s response to GILTI, if any, include the state’s general anti-anything-Trump sentiment and the fact that a new governor will be testing the political waters.
Gregory Turner of Turner Law in Sacramento said that how GILTI interacts with, overlaps, or supplants the state’s existing subpart F inclusion “is not entirely clear, as evidenced by the wide diversity of opinions out there for how California should respond.”
“The worst answer, in my view, would be to force taxpayers to run two calculations and pick the one producing the highest revenue,” Turner said.
Shanske replied that he doesn’t believe requiring taxpayers to run two calculations is a major issue.
“I don’t see the big deal doing the GILTI calculation given that one needs to do it at the federal level anyway,” Shanske said. “At the state level I am proposing a really simple apportionment formula. Besides, if a taxpayer does not like these two imperfect backup options, then they can just go with worldwide combination.”
Turner, who early in his career worked as state legislative staff, provided background about the dynamics of California’s conformity process. He said the FTB’s unwillingness to sponsor, propose, or endorse conformity on GILTI — or to the TCJA generally — “is not at all surprising to anyone out here.” While the FTB typically does not sponsor conformity legislation, Turner said it will sometimes sponsor very technical measures; more often, however, the FTB will act as technical support to a committee bill to an author that decides to take up an issue.
“Conformity has a long and tortuous history out here,” Turner said, adding that as a general matter, conformity “seldom happens as a matter of course.”
“Conformity usually happens after several years, tends to be driven by important issues as opposed to administrative convenience, and is always a bit of a slog,” Turner said. “Revenue impact drives much of the debate and usually items of measurable revenue consequence are held outside what we out here refer to as a ‘conformity bill.’”
Regarding GILTI conformity specifically, “I think it is unclear how California will proceed,” Turner said, adding that “much will be driven by the revenue implications.”
“If there is meaningful revenue in conformity, I would be surprised if there wasn’t an attempt at least,” Turner said. California has lately benefited from revenue surpluses, but “the hunt for more revenue is always on,” Turner said. The FTB in its preliminary report on specific TCJA provisions estimated that conformity could produce about $350 million annually in additional revenue. While that amount is small in comparison to the state’s $200 billion budget, it is significant enough — and controversial enough — “that it would not be introduced as part of a conformity bill in any regard,” he said.
That is, Turner said, the complexity of the issue and the revenue implications “suggest that a stand-alone bill should be anticipated, if California reacts at all.”
California’s bill filing deadline is February 22, though GILTI provisions conceivably could also become part of the state’s budget negotiations and be included in a “budget trailer” bill. “And as we saw last year with the last-minute attempt to react to Wayfair, sometimes these issues crop up in the last weeks of session in late August,” Turner said.