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Strategic Nonconformity, State Corporate Income Taxes, and the TCJA: Part II

Posted on July 13, 2020
David Gamage
David Gamage
Adam Thimmesch
Adam Thimmesch
Darien Shanske
Darien Shanske

Darien Shanske is a professor at the University of California, Davis, School of Law (King Hall), Adam Thimmesch is an associate professor of law at the University of Nebraska College of Law, and David Gamage is a professor of law at Indiana University Maurer School of Law.

In this installment of Academic Perspectives on SALT, the authors discuss strategic responses to the corporate income tax provisions of the Tax Cuts and Jobs Act.

States will soon be facing dire revenue needs because of COVID-19. This article is part of Project SAFE (State Action in Fiscal Emergencies), an academic effort to help states weather the fiscal crisis by providing policy recommendations backed by research.1 As we have explained previously,2 in the absence of sufficient federal action, states should prioritize raising revenue through targeted taxes on economic actors that are best enduring the crisis, rather than cutting services needed to protect their economies or residents suffering more from the crisis. Here we focus on how states could raise revenue by rethinking whether and how to conform to the corporate income tax provisions of the Tax Cuts and Jobs Act.

This article is the second in a two-part series. The first argued why states in general should consider strategic nonconformity with the TCJA and, specifically, how they should consider strategic responses to the TCJA’s personal income tax provisions.3 This second installment considers strategic responses to the TCJA’s corporate income tax provisions.

The TCJA’s most important corporate income tax change was to slash the federal corporate income tax rate from 35 percent to 21 percent.4 That cut had no direct effect on states, but many changes did, including another significant revenue-reducing provision: the adoption of full expensing under Section 168(k). There are also many revenue-raising provisions — including the net interest limitation in section 163(j), the transition tax under section 965, and the global intangible low-taxed income and base erosion and antiabuse tax provisions for taxpayers with international operations. States should look to all these provisions to address their revenue shortfalls.

Full Expensing

States should strongly consider decoupling from full expensing under section 168(k) if they have not already done so. That provision is generally defended either as a supply-side stimulus or a preferential step toward a tax based on cash flow. Full expensing at the state level is not appropriate under either rationale, especially during the COVID-19 fiscal crises.

First, the general economic case for full expensing is uncertain and controversial5 — especially in a world in which section 179 gives smaller firms full expensing already. Second, states are not in any position to provide economic stimulus to businesses, which is the type of assistance that should come from the federal government. This point bears repeating: The right question is not whether, all things equal, a state-level tax break would help businesses right now; of course it would. But those dollars have to come from somewhere, given state balanced-budget rules. Thus, the right question is whether a relatively small amount of state tax relief is a better use of funds than making cuts to vital services during a recession and pandemic, especially when the federal government is already providing relief through this channel.

Finally, adopting full expensing might move a state closer to what some consider a normatively superior tax base, but states can’t achieve that goal in isolation. As explained more fully in a prior article,6 there is no room in the existing corporate income tax — which both excludes borrowed funds from income and includes those amounts in an asset’s depreciable tax basis — for any interest deduction for funds used to purchase assets that are fully expensed. Therefore, it is not advisable for states to adopt full expensing as a step toward a complete restructuring of their tax systems without undergoing that complete restructuring. It is especially foolish to engage in such a restructuring during the current crisis if the transition would result in even less revenue.

If states want to move toward a corporate tax base compatible with full expensing, then we would recommend (at a minimum) that they disallow all interest payment deductions as part of their corporate tax bases. But successfully enacting this would require much broader, more involved reform than just decoupling from section 168(k), so decoupling from section 168(k) is the easiest and most straightforward path for states to follow during their budget crises.

More ambitiously, and as an extension of the foregoing logic, it would also be prudent for states to go further and consider decoupling from the accelerated depreciation generally allowed under section 168 — at least absent or until broader reform efforts consider the alternative of ending interest payment deductions and possibly including debt financing in the tax base. Again, a depreciation allowance that would more closely track economic depreciation is more justifiable within states’ current systems as a matter of income tax principle, and would help them meet their dire revenue needs.

Net Interest Limitation

States should also consider conforming to the TCJA’s new business interest deduction limitation under section 163(j)7 and decoupling from changes to that limitation in the Coronavirus Aid, Relief, and Economic Security (CARES) Act.8 The net interest limitation only limits business interest deductions that exceed 30 percent of a taxpayer’s adjusted taxable income and does not apply to taxpayers whose average annual gross receipts over an applicable three-year period do not exceed $25 million.9 Nevertheless, the provision does raise some revenue and helps offset the debt preferences in the general income tax code. States that did not conform to this TCJA provision should do so.

Further, states should decouple from the changes to the net interest limitation in the CARES Act, which relaxes the section 163(j) limitation in two major ways. First, the CARES Act raises the threshold percentage from 30 percent to 50 percent. Second, for purposes of tax reporting for 2020, the bill allows taxpayers to elect to use their 2019 ATI for making their limitation calculations rather than their 2020 ATI.10 States should not adopt these modifications, which would help some companies at the expense of the whole. States are in no position to make that trade-off.

GILTI, BEAT, and the Transition Tax

The TCJA included a few large revenue raisers in its international provisions as well. Specifically, the TCJA raised federal tax revenues through the imposition of the transition tax of section 965, GILTI, and BEAT. Each provision is aimed at addressing the income deferral and income shifting that was prevalent under prior law, and state conformity with each could raise additional revenue — which is why we suggest they do so.

Two of us coauthored a series of articles explaining the case and methods for states to broaden their corporate tax bases through conforming to these provisions,11 to which we refer interested readers for more details of what we recommend. In short, however, these federal reforms were necessitated in large part because U.S. multinationals were underreporting the income that should have been included in their U.S. tax base. That practice was partially laid bare by the fact that there are a number of foreign jurisdictions with GDP that was a fraction of the reported profits that U.S.-controlled subsidiaries attributed to those jurisdictions.12 The TCJA’s international provisions were partially aimed at correcting this prior underpayment of U.S. tax and partially at capturing any ongoing underreporting, and conformity with those provisions would be a way for states to capture revenue lost in previous tax years and to protect their tax bases from erosion. Conformity is not a cash grab as some would suggest — far from it.

The case for state conformity with these provisions was powerful even before the pandemic. Those tax base increases would have helped states account for previous losses and prepare for the next recession. The pandemic has only made the case more urgent: States should act now to conform to these TCJA provisions and broaden their tax bases.13

Conclusion

Unless the federal government takes much stronger actions than seems likely, balanced-budget constraints mean states will face dire revenue needs as a result of COVID-19. To limit the need to cut services and to protect their economies and residents who are suffering the most, states should consider a variety of options for raising revenue from those best enduring the crisis.

In this two-part series, we have proposed various ways that states should consider strategic conformity and nonconformity to the TCJA and to federal tax law more generally, as a means of raising the revenue to weather the current crisis with minimal harm to residents, state economies, and states’ general health and welfare. Because no one solution to the COVID-19 budget crises will suffice to resolve fiscal needs while minimizing these harms, we urge state lawmakers to consider quickly adopting packages of multiple coping strategies, including at least some of the revenue-raising possibilities proposed here.

FOOTNOTES

1 Gladriel Shobe et al., “Introducing Project SAFE (State Action in Fiscal Emergencies),” Tax Notes State, Apr. 27, 2020, p. 471; University of Virginia School of Law, “Project SAFE”; David Gamage and Darien Shanske, “States Should Consider Partial Wealth Tax Reforms,” Tax Notes State, May 18, 2020, p. 859; Adam Thimmesch, “State Tax Conformity: The CARES Act and Beyond,” Tax Notes State, May 25, 2020, p. 987.

2 Thimmesch, Shanske, and Gamage, “Strategic Nonconformity, State Personal Income Taxes, and the TCJA: Part I,” Tax Notes State, July 6, 2020, p. 17; Gamage, “Preventing State Budget Crises: Managing the Fiscal Volatility Problem,” 98 Cal. L. Rev. 749 (2010).

3 Thimmesch, Shanske, and Gamage, supra note 2.

4 The reduction in rates will reduce federal revenues by an estimated $1.35 trillion over a 10-year period. See Joint Committee on Taxation, “Estimated Budget Effects of the Conference Agreement for H.R. 1, The ‘Tax Cuts and Jobs Act’” (Dec. 18, 2017).  

5 See, e.g., Lily L. Batchelder, “Accounting for Behavioral Considerations in Business Tax Reform: The Case of Expensing” (Jan. 24, 2017); Steve Wamhoff and Richard Phillips, “The Failure of Expensing and Other Depreciation Tax Breaks,” Institute on Taxation and Economic Policy (Nov. 19, 2018); cf. Anna Tyger, “New Evidence on the Benefits of Full Expensing,” Tax Foundation (Aug. 15, 2019).

6 See Thimmesch, supra note 1, at 989 n.15.

8 See Thimmesch, supra note 1, at 988-89.

11 Shanske and Gamage, “Why (and How) States Should Tax the Repatriation,” State Tax Notes, Apr. 23, 2018, p. 317; Shanske and Gamage, “Why States Should Tax the GILTI,” State Tax Notes, Mar. 4, 2019, p. 751; Shanske and Gamage, “Why States Can Tax the GILTI,” State Tax Notes, Mar. 18, 2019, p. 967; Shanske and Gamage, “States Should Conform to GILTI, Part 3: Elevator Pitch and Q&A,” Tax Notes State, Oct. 14, 2019, p. 121; Shanske and Gamage, “Will States Step Up in 2020? We Hope So,” Tax Notes State, Dec. 16, 2019, p. 977.

12 “American Corporations Tell IRS That 61 Percent of Their Offshore Profits Are in 10 Tax Havens,” Institute on Taxation and Economic Policy (Nov. 5, 2017).

13 Conformity with these federal provisions would require some design considerations at the state level, which have been discussed in prior articles. “Why (and How) States Should Tax the Repatriation,” supra note 11; “Why States Can Tax the GILTI,” supra note 11.

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