Tax Reform: What the International Provisions Mean to the States

On December 22 President Trump signed the most drastic tax reform bill in more than 30 years — H.R. 1, known informally as the Tax Cuts and Jobs Act. One of the most significant changes in the law is the new international tax regime, which changes how the United States taxes multinational businesses and moves from a worldwide system of taxation to a more territorial regime. As part of this shift, a 100 percent deduction is allowed for the foreign-source portion of dividends received by U.S. shareholders from foreign corporations, and foreign corporations are subject to tax on their U.S.-source income. However, the new tax regime is most accurately described as quasi-territorial, because it retains the taxation of some foreign-source income under subpart F and still taxes domestic corporations on their income earned through foreign branches. 

As we analyze the federal tax implications of the new international tax provisions, we must also consider their potential state tax consequences. These implications add yet another layer of complexity to federal tax reform, with the possibility for results in several states that are different from those at the federal level because of state tax rules designed to address the pre-reform Internal Revenue Code. We anticipate that many states will enact legislation to address federal tax reform provisions directly, although we also anticipate that the states’ responses to the federal changes will vary widely. This article focuses on some state tax consequences and uncertainties arising, under current state laws, from the new international tax provisions. 

I. Repatriation Transition Tax

Because of the shift from a worldwide tax regime through enactment of the 100 percent dividend-received deduction (DRD) for foreign-source income received from foreign corporations, a provision has been enacted to ensure that income that has been earned by a controlled foreign corporation, but that has not yet been subject to tax under the subpart F inclusion provisions, will not escape taxation. Thus, the law’s repatriation transition (RT) provisions impose a one-time tax on foreign earnings of foreign corporations that have not been subject to federal income tax, albeit at a lower rate than the general corporate tax rate. Under the new law, accumulated foreign earnings held by some foreign corporations with U.S. shareholders will be deemed repatriated and taxed federally at a rate of 15.5 percent if attributable to cash or cash equivalents and at 8 percent if attributable to illiquid assets. The taxpayer may then elect to pay the resulting federal income tax liability over eight years. 

The RT has three components: 

• The taxpayer increases the amount of the taxable income it includes under IRC section 951(a) to reflect the deferred foreign earnings and profits of its foreign corporate subsidiaries (the RT addition).

• The taxpayer takes a deduction under IRC section 965 equal to an amount that would result in the taxpayer being subject to an 8 percent tax on the amount by which its RT addition exceeds its aggregate foreign cash position, plus an amount that would result in the taxpayer being subject to a 15.5 percent tax rate on the amount of the taxpayer’s aggregate foreign cash position that does not exceed the taxpayer’s RT addition (collectively, the RT deduction).

• The taxpayer can elect to defer payment of the RT tax liability by paying in eight installments, each of which is computed based on a percentage of the RT tax liability. 

A. State Tax Implications of the RT Addition

Because states generally use federal taxable income as the starting point for their state income tax bases, the RT addition should automatically increase a taxpayer’s state tax base unless the state has a specific modification that will apply. For example, some states provide an explicit modification for some income received from enrolled foreign corporations, while others treat such income as a dividend eligible for a DRD. Some states, however, would include the income from the RT addition in determining the state tax base either because they do not provide a DRD, or because they do not consider income that is in a taxpayer’s federal taxable income under IRC section 951(a) to be a dividend. 

B. State Tax Implications of the RT Deduction

In some states, whether the RT deduction is allowed in determining the tax base may depend on whether the RT deduction is considered a special deduction for federal income tax purposes. More specifically, some states require that the starting point for determining a taxpayer’s state tax base be the taxpayer’s federal taxable income before any special deductions have been taken. The IRC describes special deductions as those set forth in subtitle A, chapter 1, subchapter B, Part VIII of the IRC. Accordingly, the RT deduction should not be considered a special deduction because it is imposed by IRC section 965, which is not in Part VIII. 

However, in 2005 the IRS did include the section 965 temporary DRD regarding repatriated dividends as a special deduction on Form 1120, even though section 965 is not in Part VIII. Even if the RT deduction is similarly reflected on the federal tax return as a special deduction, that placement should not cause the RT deduction to be a special deduction because placement of an item on a federal tax return should not overrule the statutory language in the IRC.¹ Thus, if a state specifies that the starting point for its state tax base is federal taxable income before special deductions, the better argument seems to be that the RT deduction is allowed in determining the state tax base, regardless of whether the IRS reflects the RT deduction as a special deduction on Form 1120. If a statute specifies that the starting point in determining the state tax base is income as reported on Line 28 of the taxpayer’s federal Form 1120 (instead of specifying that the starting point is taxable income before the deduction of special deductions), the placement of the RT deduction on the federal Form 1120 could become much more important. 

In states where the RT deduction is allowed in determining the starting point of a taxpayer’s state tax base, there may be no state modification that would apply to add back the RT deduction to the tax base unless the state has a specific reference to IRC section 965 or if the RT deduction is deemed a DRD. To the extent that a state provides a deduction or exclusion for the RT addition as a dividend but does not exclude the RT deduction in determining the taxpayer’s state tax base, a taxpayer could end up with a windfall. However, it seems likely that such states would take the position that the RT deduction is a DRD that must be added back under any DRD provision. 

C. State Tax Implications of Tax Payment Deferral

Deferring payment of any increased tax liability resulting from the RT provisions would likely not be effective in most, if not all, jurisdictions. At the federal level any such election triggers a deferral of the time for paying the tax, not a deferral of inclusion of the RT addition in taxable income. Accordingly, absent legislative changes, all state tax liability or benefit resulting from the RT provisions would likely be required to be paid or recognized in the 2017 tax year. 

D. RT Conclusion

For states that do not exclude income received from CFCs under IRC section 951(a) (subpart F income), the effective net inclusion of the RT addition and the RT deduction in the states’ tax base should be the same as the net amount in federal taxable income. It is unlikely that taxpayers would be able to spread their state tax payments over eight years unless the states change their laws to allow for such deferral. Accordingly, because of the substantial amount of income that may be included in the state tax base as a result of the RT provisions, even when the RT addition is netted by the RT deduction, a constitutional issue — namely, factor representation/fair apportionment — may arise in states that do not include the factors of the foreign corporations that generated the subpart F income in determining the taxpayer’s apportionment formula. While the constitutionality issue may exist under the current subpart F income inclusion rules, it could be even more critical regarding amounts included under the RT provisions because the amount of the increase in the tax base from the RT provisions may be substantial and, thus, exclusion of the foreign corporation’s factors in a taxpayer’s apportionment formula could create substantial distortion. 

On the other hand, in those states that do exclude subpart F income, taxpayers may be able to exclude the RT addition but still be entitled to the RT deduction. Taxpayers in those states could end up with a windfall. To avoid that, it appears likely that the affected states would try to construe the RT deduction as a DRD that should be added back. That argument could be compelling because otherwise there may be a phantom loss in computing the taxpayer’s state tax base. It is also likely that states in which taxpayers may generate a windfall under the current state laws will change their laws to avoid that result. 

II. New Taxable Income Provisions

Under the new hybrid territorial tax regime, there are significant changes in the tax base of a U.S. shareholder of a foreign corporation. Foremost is that dividends received from 10-percent-owned foreign corporations are eligible for a 100 percent DRD. The new regime also creates new categories of income and deductions, such as the inclusion of global intangible low-taxed income (GILTI), which is taxed at a reduced rate, and the deduction for foreign-derived intangible income (FDII). Also, the transfer pricing provisions have been expanded. 

A. Dividend-Received Deduction

Under the new regime, domestic corporate shareholders of 10-percent-owned foreign corporations will be able to take a 100 percent DRD for the foreign-source portion of some dividends received.² While beyond the scope of this article, it should be noted that there are several restrictions on the eligibility of some dividends for the DRD. For example, the deduction is unavailable for some hybrid dividends for which the distributing corporation received a benefit regarding taxes imposed by a foreign country. 

The state implications of the 100 percent DRD depends on the state’s treatment of dividends. In some states, the change at the federal level will have no effect, either because dividends were already eligible for a complete deduction in the state — as in Delaware³ — or because only a partial deduction is allowed — as in California.⁴ Some states, like Tennessee, use the federal starting point and then allow a deduction for dividends received by a taxpayer from a corporation of which it owns 80 percent or more of the capital stock. Thus, to the extent a U.S. shareholder owns less than 80 percent of a foreign corporation’s capital stock, the new DRD could have an effect in Tennessee.⁵ 

B. GILTI

The new legislation taxes GILTI at a reduced effective rate of 10.5 percent (13.125 percent beginning in 2026) in an effort to tax a portion of the active (non-subpart F) income of CFCs — that portion of the CFCs’ income that is equal to the excess of an implied 10 percent rate of return on the CFCs’ adjusted bases in tangible depreciable property used to generate active income.  

As with the RT, the method used to impose a reduced tax rate on GILTI relies on including GILTI in a U.S. shareholder’s taxable income, while deducting a percentage of that included amount to achieve the desired reduced effective tax rate. The GILTI regime, thus, consists of two components: 

• The taxpayer includes the GILTI of its CFCs in its taxable income under newly added section 951A (not 951(a)) (the GILTI addition); and

• The taxpayer takes a deduction under new IRC section 250 equal to, at most, 50 percent of the GILTI addition plus any corresponding section 78 gross-up (the GILTI deduction). 

1. State tax implications of the GILTI addition

Because states generally use federal taxable income as the starting point for their state income tax bases, the GILTI addition should automatically result in an increase to the state tax base unless the state has an exclusion that could apply to the GILTI addition. For example, there may be a position that the subpart F income received from the CFC is a dividend such that the GILTI addition is excluded in states that have exclusions for dividends. However, since section 951A is a new IRC section, there is no authority determining whether the GILTI addition is a dividend and, since it is not computed based on a corporation’s E&P, it is unclear how that issue would ultimately be decided. 

Further, if the GILTI addition is in the state tax base, a taxpayer could argue that factor representation mandates including a portion of the CFCs’ receipts in the receipts factor. 

2. State tax implications of the GILTI deduction

The GILTI deduction is in IRC section 250, which is in Part VIII; thus, it is a special deduction for federal income tax purposes. Because the GILTI deduction is a special deduction, whether it will be in a state’s tax base depends on whether the starting point for taxable income in the jurisdiction is federal taxable income before or after special deductions. In states where the starting point is federal taxable income after special deductions have been taken, the net GILTI inclusion should be the same as it would be for federal income tax purposes, absent a specific state modification. In states where the starting point is federal taxable income before special deductions, the taxpayer would be required to include the GILTI addition in taxable income but would not be entitled to the GILTI deduction, absent a specific state modification. 

3. GILTI conclusion

For states that do not have exclusions that could apply to the GILTI addition and the GILTI deduction, the effective net inclusion in the state’s tax base should be equal to the net amount in federal taxable income. However, in some states the entire amount of the GILTI addition may be included in the state tax base with no corresponding offset for the GILTI deduction. The constitutional issues will become even more critical in those states, as the amount of income included could be more substantial and, thus, potentially more distortive. 

We expect that many states will enact legislation to adapt their tax laws to address the components of federal tax reform. We expect that taxpayers will encourage states to change laws that currently include the GILTI addition in the tax base but do not allow for the GILTI deduction. 

C. The FDII Deduction

To discourage companies from moving and holding intangible assets outside the United States, the new IRC section 250 allows a deduction for income earned by corporate U.S. taxpayers from selling property or providing services outside the United States (the FDII deduction). Accordingly, U.S. shareholders are entitled to a deduction under new IRC section 250 equal to, at most, 37.5 percent of the taxpayer’s foreign-derived intangible income. 

The state tax implications of the FDII deduction should be like those of the GILTI deduction because both are special deductions under the IRC. Accordingly, because the FDII deduction is a special deduction, whether it will be in the state tax base depends on whether the state sets its starting point for taxable income before or after special federal deductions. In states where the starting point is federal taxable income after special deductions have been taken, the FDII deduction should be allowed in computing the state tax base absent a state addback. (While unclear, it is likely that addbacks for DRDs or subpart F modifications will not apply to the FDII deduction.) The FDII deduction will likely not be allowed in states where the starting point for computing the state tax base is federal taxable income before special deductions. As discussed above, it is critical to look at the state statutes to determine the starting point for computing the state tax base.⁶ 

D. Expanded Transfer Pricing Rules 

The new legislation has significantly expanded the federal transfer pricing rules in IRC section 482, expanding the definition of intangible property to include any item of potential value that is not attributable to tangible property or the services of an individual, including goodwill, going concern value, and workforce in place. Also, the legislation authorizes the IRS to value transfers of intangible property on an aggregate basis with the transfer of other property or services if the use of such aggregate basis is determined to be the most reliable means of valuing such property. 

State taxing authorities, particularly those with separate company filing regimes, have been increasingly focused on, and more aggressively applying, federal transfer pricing principles. We expect that the states will be quick to apply the expanded federal transfer pricing provisions. Further, even though the federal rules become effective for transactions in 2018, it is possible that the states will apply the new principles in audits for tax years before 2018 because the states are frequently aggressive in their use of transfer pricing principles. 

III. The New Alternative Minimum Tax

In addition to changes affecting the tax base for federal income tax purposes, the new tax bill has several base erosion measures, including a new base erosion and antiabuse tax (BEAT). 

The BEAT is an alternative minimum tax, effective beginning in 2018, that is designed to reduce earnings stripping by U.S. taxpayers through payments to foreign affiliates.⁷ That AMT is designed to prevent the base erosion from companies serving the U.S. market through foreign affiliates in low- or no-tax jurisdictions. 

Absent state legislation, the BEAT will likely have no effect on a corporation’s tax liability in any state because the BEAT is imposed as an alternative tax. Because most state tax bases are based on federal gross income or federal taxable income, and the BEAT does not change a taxpayer’s federal gross income or taxable income, the BEAT should have no state tax implications. 

IV. Conclusion

In determining the proper state tax treatment of the new hybrid territorial international tax regime, taxpayers must analyze both the IRC implementation language and the language in the state’s statutes. The provisions discussed in this article will have diverse impacts in different states. These issues should be monitored carefully as it is likely that many states will change their laws to address these issues directly.