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Offset Provision Guidance Could Be Thorny for States Eyeing Tax Cuts

Posted on May 17, 2021

Treasury’s interim guidance on the emergency funds provided by the federal government to state and local governments is helpful but could also complicate policymaking in states looking to reduce taxes, according to tax practitioners.

Treasury on May 10 released an interim final rule providing guidance on how $350 billion in emergency funding for state, local, territorial, and tribal governments included in the American Rescue Plan Act of 2021 (P.L. 117-2) can and can’t be used.

The guidance provides clarification on a provision that restricts the aid from being used to offset a reduction in net tax revenue. Under the act, states or territories that use the aid to cut taxes are required to repay the funds to the federal government.

The provision, which was added to the bill by Senate Democrats, has drawn criticism from Republicans, who argue that it ignores states’ authority to create their own fiscal policies. It has been the subject of several lawsuits filed by state attorneys general.

The 151-page interim final rule, posted on Treasury’s website, lays out a framework with a process for determining whether the funds have been used to offset a reduction in net tax revenue and explains how the recapture provision works and how it is computed.

“What is not allowable as a general matter is using the federal funds to reduce taxes and tax expenditures,” according to Jeff Friedman, partner at Eversheds Sutherland (US) LLP. “And that’s not just decreasing tax rates or creating exemptions but also credits and through guidance and other methods the state or locality could use to reduce revenues.”

Friedman said the Treasury guidance is helpful in that it provides rules and a safe harbor for states and localities to abide by. “But it creates such elaborate, expansive rules about what a tax expenditure is and . . . whether there is an actual tax decrease or not,” he said.

Treasury’s guidance includes a de minimis level, which allows states to lower revenue by 1 percent of the baseline — to be calculated as fiscal 2019 “tax revenue indexed for inflation in each year of the covered period” — without triggering the clawback. According to the guidance, “the de minimis level recognizes the inherent challenges and uncertainties that recipient governments face, and thus allows relatively small reductions in tax revenue without consequence.”

It also includes a safe harbor. Under the guidance, governments are to compare the reporting year’s actual tax revenue to the baseline. “If actual tax revenue is greater than the baseline, Treasury will deem the recipient government not to have any recognized net reduction for the reporting year, and therefore to be in a safe harbor and outside the ambit of the offset provision,” the guidance states. 

Katie Quinn, partner at McDermott Will & Emery, said she thinks the calculation will benefit states that saw population growth, such as Florida and Texas.

The interim final rule also explains that states can’t use the federal funds to offset a reduction in net tax revenue but can use three other sources to offset the reduction — organic growth, increases in revenue such as a tax increase, and spending cuts.

Practitioners said it is good news that Treasury will allow organic growth to count toward offsetting tax reductions.

With the U.S. economy expanding after economic stimulus and with more people getting vaccinated, the economic growth “could make the vast majority of this discussion moot,” Friedman said.

“If states are going to be collecting tax revenues hand over fist . . . that could offset so significantly other types of tax decreases that the federal limitation won’t get triggered in many instances,” Friedman said.

Bill Backstrom, tax practice group leader at Jones Walker LLP, told Tax Notes that the guidance considers the offset provision “using a holistic approach rather than bill-by-bill or change-by-change.”

“It gives the states in computing the overall impact of tax bills [the ability] to take into account tax increases, spending cuts, and organic revenue growth,” Backstrom said.

Jamie Yesnowitz, principal at Grant Thornton LLP, said he thinks the process created by Treasury for states to ensure they don’t have to repay the funds will be challenging to comply with and probably even more difficult for localities with fewer resources.

“The question of whether their policies work is going to come down to legislators every time they introduce a bill. It’s going to need some sort of analysis, not just from a scoring aspect, how much revenue will the bill bring in, how much revenue will it take away,” Yesnowitz said. “It’s going to make things very challenging for legislatures to come up with concrete policies.”

The burden will likely fall on revenue estimators to figure out whether policies will violate the offset provision, according to Backstrom. In addition to usual budgeting efforts, they will have to account for how policies will affect whether the state will have to repay federal funds, Yesnowitz said.

Now states will be in the same position as taxpayers, in which they are subject to audit, Backstrom said. “It flips — I think it’s going to be interesting,” he added.

Practitioners also say that the clawback provision might be difficult for Treasury to enforce.

Backstrom said he also wonders whether there are enough resources at the federal level to pursue collections. “I think it’s going to be administratively burdensome on the Treasury Department and the states to defend against Treasury to recoup the money,” he said.

IRC Conformity

Treasury in the interim final rule states that it “has determined and previously announced that income tax changes — even those made during the covered period — that simply conform with recent changes in federal law (including those to conform to recent changes in Federal taxation of unemployment insurance benefits and taxation of loan forgiveness under the Paycheck Protection Program) are permissible under the offset provision.”

The department announced April 7 that “regardless of the particular method of conformity and the effect on net tax revenue, Treasury views such changes as permissible under the offset provision.”

Some practitioners interpret the guidance as not penalizing states for adopting a conformity provision that would result in a revenue reduction. Others interpret it to mean that states can also decouple from changes to the IRC.

Quinn said she thinks the guidance gives any state legislature that was hesitant to decouple from global intangible low-taxed income — established by the Tax Cuts and Jobs Act — the green light.

But Yesnowitz said he “wouldn’t go as far as to say that any federal change for state purposes is automatically OK.”

“Decoupling from, say, GILTI, is not a tax decrease; it’s an act to prevent a tax increase,” said Quinn, whose firm is part of the State Taxes After Reform and Recession (STARR) Partnership, which has pushed for states to decouple from GILTI and other base-broadening provisions of the TCJA.

Litigation

A bipartisan group of attorneys general in 13 states has filed suit against the federal government over the offset provision, as have attorneys general for Arizona, Kentucky, Louisiana, Mississippi, Missouri, Ohio, Tennessee, and Texas.

A federal judge dismissed Missouri’s suit May 11 on grounds that the state lacks standing and the challenge is not yet ripe.

A federal judge denied Ohio’s motion for preliminary injunction seeking to block Treasury from enforcing the offset provision in a May 12 decision. However, the judge determined that the court has jurisdiction and that the state has “established a substantial likelihood (although by no means a certainty) of success on at least an aspect of its Spending Clause claim, and that Ohio is currently suffering irreparable harm.”

Yesnowitz said as the litigation proceeds, both sides should have an opportunity to address the effect of the guidance.

“Not surprisingly, I think both sides will claim that the guidance supports their overall arguments — the federal government will claim that the guidance sets forth a reasonable method by which the statutory provision can be administered, while the parties challenging the provision will claim that the guidance makes compliance with the provision impossible because of ambiguity and complexity," Yesnowitz said.

“Based on the fact that the interim guidance is not final and may be revised in the near future, I think the courts will wait to see if that happens before determining how much weight should be given to the guidance in evaluating the constitutional issues,” Yesnowitz added.

Friedman said he thinks the framework set forth by Treasury will “play into the hands of those litigating that this is overstepping by the federal government.”

“I think ultimately the litigation will be the most interesting part of all of this,” Friedman said. “I think that sooner or later we’ll see one of these cases progress on the merits.”

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