David Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Worldwide Tax Daily. This week: GILTI or not GILTI, state edition. With the passage of the Tax Cuts and Jobs Act, state lawmakers were left with a new dilemma, whether to conform their income tax systems to include global intangible [low-taxed income] provisions or not. Over the past few months, we've seen states take differing approaches, and we're going to take a look at where things stand. I'm joined in the studio by State Tax Today reporter Paige Jones and Worldwide Tax Daily senior legal reporter Andrew Velarde. Paige, Andrew, welcome back to the podcast.
Paige Jones: Thanks for having us.
Andrew Velarde: Hi, Dave, good to be here.
David Stewart: Now, before we get to the state issues, Andrew, I understand you talked to somebody about where the federal rules stand on GILTI. Who did you talk to, and what did they have to say?
Andrew Velarde: I chatted with Joe Calianno of BDO. He's the international technical tax practice leader at the firm's national office. We chatted on May 20 about pending guidance that's due out soon. We're waiting on the final version of the GILTI regs. And we chatted about a few of the changes he was hoping to see between the proposed regs as they stand now and the final regs when they are released in the near future.
David Stewart: Paige, you spoke to someone about the various approaches states have taken. Who did you talk to, and what did you hear?
Paige Jones: I chatted with Scott Smith, also of BDO. He is the national technical practice leader for state and local tax. We chatted about how states are reacting to GILTI, and some of the specific states that are taking a different approach, including New Jersey, New York, and Connecticut.
David Stewart: All right, let's go to those interviews. And I should note before we get started that these interviews were conducted by phone, and at one point a rather loud siren went by the studio, so you may hear that in the background. Enjoy.
Andrew Velarde: Hi, Joe, welcome to the podcast.
Joe Calianno: Oh, thank you, Andrew, looking forward to talking with you.
Andrew Velarde: Before we get into the specifics, I'd like to just establish a little background here for our listeners on GILTI generally. GILTI, acting somewhat as a minimum tax, each U.S. shareholder of a controlled foreign corporation is subject to tax on GILTI. Which is defined as the excess of its pro rata share of tested CFC income over a 10 percent return on its pro rata share of the depreciable tangible property of each CFC. This last term being known as the qualified business asset investment, or QBAI. Now, we had proposed regs [that] were released in September, and there's some indication that they will be finalized soon. Treasury said they're aiming to beat that June 22 deadline for retroactivity. And in fact, the final regs reached OIRA review last week. And we're gonna talk about two provisions more specifically that have received a lot of attention from practitioners. And Joe, that's where I'm hoping you can provide a little more insight to this conversation. The first provision is the anti-abuse rule under [prop. reg.] section 1.951-1e(6). Under that provision, a transaction that is part of a plan with a principal purpose of tax avoidance, including through a reduction of CFC subpart f income is disregarded in determining the pro rata share of the subpart f income of the corporation. This rule applies to GILTI as well. Now, practitioners have criticized this rule. Joe, can you provide some insights as to why, and what changes to the rule are you hoping for in the final regs?
Joe Calianno: Thanks, Andrew. So as a starting point, this rule is extremely broad in its wording. I think the concern surrounding this rule is when the IRS may try to apply this rule. There are a number of real economic restructuring transactions where subpart f inclusion or GILTI inclusion may be reduced as a result of the restructuring. The concern revolves around whether because there is a reduction in subpart f income or GILTI, the IRS potentially may be looking to apply this rule to those types of transactions. For instance, suppose you have a liquidation or reorganization of CFCs and the U.S. shareholder’s subpart f income or GILTI inclusion is reduced following the transaction. Alternatively, suppose you have a U.S. corporation that distributes the CFC to its foreign parents such that the U.S. company is no longer a U.S. shareholder following the transaction. Are these common restructuring transactions the type of transactions that the IRS is really targeting by this rule? Or are they just focusing on noneconomic type allocations or transactions? So language in the rule is pretty broad as currently written, so that's the concern. In any event, for the IRS to apply this rule, [it] must be shown, as you mentioned, that the transaction arrangement is part of a plan and principal purpose of avoiding federal income tax, including reducing your subpart f or GILTI. Also, there's uncertainty as to what it means to disregard a transaction where the rule actually does apply. What are the collateral consequences of when a transaction is disregarded? Those are the kinds of things that there's a lack of clarity. The hope is that when the IRS and Treasury finalize regulations, they'll scale back this rule. Hopefully they'll provide a less broad, more targeted rule. Right now, because of the language used in the regulation, there is uncertainty as to whether specific types of transactions or arrangements — what types they are targeting. Hopefully they will be targeting noneconomic arrangements or transactions, not common restructuring transactions even though U.S. shareholders subpart f or GILTI inclusion may be reduced. I believe the IRS says they are aware of these concerns expressed by taxpayers and practitioners relating to the breadth of the rule, and hopefully will rethink this rule when they finalize regulation.
Andrew Velarde: Thank you, Joe. Let's pivot now to a second provision that I wanna highlight here, and that's the fact that we have no high-tax exception for GILTI. Generally, a high-tax exception exempts foreign income from additional U.S. tax to the extent the rate of the foreign tax on income exceeds 90 percent of the U.S. corporate rates. Under section 951A, you only exclude from tested income high-tax income that is otherwise subpart f income. So because of this, as well as the allocation of expenses in GILTI in relation to foreign tax credits, which I don't wanna get into right now — that's far too broad a topic by itself. But we've heard that some taxpayers are considering the previously unthinkable option of making more income subject to subpart F to better limit U.S. tax liability. So my line of questions for you, Joe, on this is was this rule expected, and have you witnessed taxpayer planning around this? And furthermore, why should Treasury change it, and how do you think this will be resolved in the final rules?
Joe Calianno: OK, there's a lot there, so I'll try to maybe give a little background here to give some context. So as a starting point, whether a taxpayer has a better tax result having a subpart f inclusion versus a GILTI income inclusion is a modeling exercise. If income is subpart f income, it is excluded from tested income under GILTI. To the extent a taxpayer has high tax subpart f income and such income is excluded as a result of the subpart f high-tax exception under [section] 954 before. Such income is excluded both from subpart f income and tested income under the GILTI rules. Thus such income would not be taxed under either antideferral regime. Also in this situation, if you're a domestic C corporation, you may be able to distribute those earnings that aren't taxed, and they're excluded from both subpart f and GILTI from your CFCs. You may be able to distribute those earnings from your CFCs and qualify for 100 percent [dividends received deduction (DRD)] under [section] 245A if you satisfy certain requirements. So as it relates to subpart F income and GILTI, it may be worth noting some of the differences between the two. For instance, as it relates to GILTI, under section 250 a domestic corp. may be able to receive up to a 50 percent deduction, assuming the domestic corporation has sufficient taxable income. So with the section 250 deduction, the tax rate can be cut down to 10.5 percent on the GILTI inclusion. As it relates to a domestic corporation claiming foreign tax credits related to a GILTI inclusion, there's a 20 percent haircut on the deemed-paid foreign tax credits. And there's no carryback or carryforward of the foreign taxes. One of the questions is whether the domestic corporation's gonna be able to utilize the foreign tax credit in the current year because of the various foreign tax credit limitations that may or may not apply. With subpart F income, there's no [section] 250 deduction. However, you don't have the haircut, the deemed-paid foreign taxes associated with the subpart F inclusion. Also, there's an ability to carry forward the deemed-paid credits if you can't use them all in the current year. This ability to carry forward foreign tax credits can be very beneficial to some taxpayers, some domestic corporations. So comparing the results of having a GILTI inclusion versus subpart F inclusion, that's what we discuss in the tax community and has been the topic of several external panels, including structures to convert tested income into subpart F income and in some cases, subpart F income that would qualify for the subpart F high-tax exception. Whether a taxpayer gets a better result having a GILTI inclusion or subpart F inclusion, varied taxpayer by taxpayer depending on the taxpayer's particular posture. In the ideal world, if a CFC's income is neither subpart F nor GILTI, for instance, because the subpart F high-tax kickout, that can be really beneficial if you're a domestic C corp. As I mentioned earlier, those earnings might be able to qualify for the 100 percent DRD when they're distributed. Andrew, one other point I think that's worth noting and just talking about this is an individual making a [section] 962 election may be able to get the benefit of claiming the [section] 250 deduction for GILTI and deemed-paid foreign tax credits. However, there's certain nuances when an individual that's eligible to make a [section] 962 election does. So I'm not gonna go too much into that. But I wanna turn back to your question as it relates to the subpart F high-tax carveout for purposes of determining tested income and tested loss. The statute under [section] 951A provides an exclusion from tested income or tested loss for any gross income excluded from the foreign-based company income and insurance income of such corporation by reason of section 954(b)(4). Thus, if you look at the statute, it ties the kickout to subpart F high-tax income. When IRS and Treasury issued proposed regulations, they took a very similar approach. Maybe that wasn't that much of a surprise given the statutory line. However, the IRS and Treasury have received and continue to receive a lot of comments about providing a more general high-tax exception for purposes of determining tested income and tested loss, not necessarily tied to the subpart F high-tax kickout. From a policy standpoint, it does seem to make sense to have a high-tax kickout even if it's not tied to the subpart F high-tax kickout. Hopefully the IRS and Treasury will reconsider this exception when they finalize the GILTI regulations.
Andrew Velarde: Thank you, Joe. Now I'd like to kick it over to my colleague, Paige, who's gonna discuss some of the state issues with GILTI.
Paige Jones: Thanks, Andrew. So joining me today on the second part of the podcast is Scott Smith, who is also from BDO. Welcome, Scott.
Scott Smith: Hi Paige, glad to be here.
Paige Jones: So now we've seen states tackle GILTI in a number of different ways, both in how they approach the provision and the vehicle for their decision. And by that I mean whether it's through legislation or administrative guidance. So let's start with a quick overview of how states have reacted to GILTI and how they've gone about doing so.
Scott Smith: OK. Well, as just about everything when it comes to state corporate income tax conformity or nonconformity with the Internal Revenue Code, there are a number of different considerations at play when we take a look at how the different states are reacting to GILTI on the federal level. Now first is whether a state is going to include the section 951A GILTI income in state taxable income or exclude it during an existing DRD provision or a provision that, for example, may apply to exclude subpart F income. And if they do so, whether the state includes it or excludes GILTI from state taxable income, will they do so on a net basis? So after the section 250 deduction or on a gross basis? So without respect to the section 250 deduction, which is then the next issue that we're seeing, and that is how are states addressing the section 250(a)(1)B GILTI deduction and whether or not they are allowing that deduction is varying across the state. And then there are two other more policy issues I think at play as well with respect to GILTI. And the first is based on certain, what I'd characterize as structural aspects of state corporate income taxes. So whether a state is a separate return state or a state that requires quote-unquote water's-edge combined reporting. There could be some risks of double taxation also at play, which have raised concerns among a number of corporate taxpayers, as well as other commentators. And then lastly, there's probably roughly half of the states [that] have yet to address GILTI and how they will deal with it. And among those states, you have about eight that have not conformed to the Tax Cuts and Jobs Act. And so we're left with the question, well, how will they deal with GILTI if or when they finally do conform with the Tax Cuts and Jobs Act?
Paige Jones: What are some of the different ways in which states are subjecting GILTI to corporate income tax or not as the case may be?
Scott Smith: As I said, you've got about half of the states that have either not conformed or there's some silence or some uncertainty as to exactly how they will treat GILTI. Of the other half, about 15 or 16 states will provide their existing or will apply their existing dividends received deduction or foreign-source dividends to GILTI income. And the main issue for the so-called DRD states first is whether their DRD will apply to the gross amount of GILTI income or only the net amount after the section 250 deduction. Then whether even after applying their DRD, whether they will separately require an addback for state taxable income purposes of the section 250 deduction that was taken for federal. So those are two key issues. And then once you figure out, well, what the DRD is going to apply to, does the state provide a full 100 percent DRD or exclusion for GILTI income, or is it some partial DRD? A number of states only provide an 80 percent DRD for foreign-source dividends. And so a number of those are applying that same DRD to GILTI income. And then lastly, a key concern for some states is the disallowance of expenses that the state deems to be attributable to deductible income, including deductible GILTI income and whether a state will apply those expense attribution and disallowance provisions to GILTI. And we're seeing it being done with respect to Connecticut, for example, which arbitrarily applies a 5 percent rule to the — they otherwise will provide a 100 percent DRD to GILTI income. However, they deemed 5 percent of that amount to be attributable to expenses. So what they essentially do, what Connecticut essentially does, is apply a 95 percent DRD. Well, it sounds like a nice number. However, that 5 percent amount of the GILTI can be substantial. The next group would be the states that flat-out tax the GILTI, and these are conforming states. They are conforming to the federal tax treatment. So for example, New Jersey will include the amount of GILTI income in what New Jersey characterizes as New Jersey entire net income. But they'll also allow or conform to the federal section 250 deduction. So there are about six states that are conforming with the federal treatment of GILTI as well as the GILTI production.
Paige Jones: In the state tax world, there's been a decent amount of discussion about New Jersey's approach to GILTI, which some practitioners have said it's controversial and it could be ripe for litigation. Could you give us an overview of that guidance?
Scott Smith: Right, so as I said, New Jersey is one of the states that will conform with the federal treatment of GILTI which means they will include it in New Jersey entire net income. And then they'll also allow a corporate taxpayer to take the section 250 GILTI deduction. However, where New Jersey is unique and controversial is in how it will apportion the GILTI income.
Paige Jones: And so how is this different from other states? Is this something that practitioners, that you're hearing is something very controversial, and that they're taking sides on?
Scott Smith: It's very odd, what New Jersey is trying to do. So you know, most states will apportion income using a formula. Usually that formula consists of the taxpayer's property, payroll, and sales. Or more commonly, nowadays, is just a single-sales-factor apportionment formula. That's been done, that's accepted, it passed constitutional muster, and that type of formulary apportionment is widely accepted. What New Jersey is doing legislatively is carving out a special apportionment formula only for GILTI income. And it's a formula that really has nothing to do with an individual taxpayer's business activity per se. Rather, it uses a New Jersey, or a GDP-type formula, which looks to the New Jersey GDP for, let's say, the 2018 taxable year over or divided by the total global GDP for where that taxpayer or the U.S. shareholder is doing business, both within the United States and outside. So on the basis of that ratio, that's the controversy, is New Jersey using that GDP, based on a New Jersey GDP ratio, is [that] what they are using to apportion GILTI income?
Paige Jones: Are there any other states that are taking a very different or more unique approach to GILTI, and, if so, what are those states doing?
Scott Smith: Yeah/ New York and Maryland are probably two other states to highlight. First of all, they're both examples of states that have a exclusion or a subtraction modification that they apply to subpart F income. And one would think, well GILTI is a type of subpart F income. So therefore, why wouldn't the New York or the Maryland subtractions also apply to GILTI? Well, that's because they're very narrowly phrased in the statute to apply only to income that's included for federal purposes under section 951 of the Internal Revenue Code. And as we know, GILTI — even though it's included in subpart F of the Internal Revenue Code — it is income that's included in federal gross income by reference to section 951A. So by their terms, they're not broad enough to apply — these New York and Maryland subtractions are not broad enough to apply to GILTI. Now New York, although it will include GILTI in New York entire net income, it does conform with the section 250 GILTI deduction. And then New York, unlike New Jersey, will apportion GILTI using its normal standard single-sales-factor formula and will, by statute, requires the GILTI to be sourced to the denominator of the formula. So that results in somewhat less of the GILTI income being apportioned to and then ultimately taxed by New York. Maryland, on the other hand, like New York, has the same statutory limitation on its subpart F subtraction. So Maryland will also include the gross amount of GILTI; they will provide a separate deduction for the section 250 GILTI deduction. But then Maryland will source the GILTI income for purposes of the Maryland sales factor based on the U.S. shareholder’s average Maryland property and payroll. So if the Maryland taxpayer happens to have a substantial amount of Maryland property and payroll, a corresponding amount of the GILTI income will be sourced to the Maryland sales factor numerator, thereby increasing the amount of GILTI income ultimately apportioned to Maryland and taxed by Maryland. So that's another little unique apportionment treatment of GILTI income as illustrated by the state of Maryland.
Paige Jones: You mentioned this a little bit at the beginning, but there has been some discussion that GILTI could be deemed as double taxation at the state level. Can you give us some insight as to why that might be?
Scott Smith: There are two general ways in which that risk of multiple taxation could arise. The first — and what has been getting a fair amount of press — has been, so if you have a separate return state that happens to include GILTI income and state taxable income. Well there are those who would argue that if that separate return state does not also include similar GILTI income of a domestic U.S. subsidiary — and it won't do that because it's a separate return state and structurally it does not tax corporate income in a combined manner; it taxes corporate income on a separate entity base — there are those that argue that's discrimination; that discriminates against foreign commerce. You're taxing income of a foreign subsidiary, but you're not taxing similar income of a domestic U.S. subsidiary. That's facially, inherently discriminatory against foreign commerce. And there are those who would contend that the Kraft v. Iowa case would support a taxpayer who's making that argument. That's the first type of potential unconstitutional multiple taxation that's occurring. The second type is a more structural kind that results from those states that require the use of water's-edge combined reporting. And normally a water's-edge combined group includes only U.S. corporations, affiliates that are engaged in a unitary business. However, certain foreign corporations can also be included in a water's-edge combined group. And those mainly are, there are two key types that their inclusion could result in multiple taxation of GILTI income. First, some states will include a foreign subsidiary that earns 20 percent or more of this income from services or intangible property transactions with U.S.-based water's-edge group members. And so if that foreign subsidiary has GILTI income and is also included in the water's-edge group, you have a potential double inclusion of the GILTI income: the GILTI income by the U.S. shareholder and a corresponding amount of the foreign subsidiary's intangible income or services income that are earned from transactions with a U.S.-based affiliate. Then the other type is a so-called tax haven corporation. Some water's-edge states will include a foreign corporation that's organized in or even doing business in a tax haven, which is either listed in the state statute by name or based on a state's criteria for defining a tax haven. So that’s a similar result. You could have a U.S. shareholder picking up the GILTI income of this foreign subsidiary, but the foreign subsidiary also has its own income from transactions with other entities in the related groups, and so there could be some multiple taxation as a result there. So those are the two principal areas where state taxation of GILTI income could raise the specter of double taxation.
Paige Jones: Going quickly back to what Andrew and Joe were talking about earlier in the episode regarding the upcoming finalized federal rules on GILTI, do you think these will have any impact on the states? Is there anything that the states should be on the lookout for or be aware of in regard to these rules?
Scott Smith: Yeah, whenever the Feds, and here the IRS is issuing regulations that are going to provide definitions and will help determine the GILTI income calculations and the deductions. Those are always going to have some trickle-down effect on states. So they're always important to understand how that federal result is reached. But also, because it's always so important in the corporate income tax context at the state level to understand the interplay between federal consolidated returns and both states' separate returns as well as unitary combined reports, there can be additional issues of federal nonconformity that can complicate matters. So those are always very important to see how a federal provision is applied in a federal consolidated context, but then how that in turn relates to a state tax return that can create some important considerations.
Paige Jones: Thank you for joining me on the podcast, Scott.
Scott Smith: Thank you for having me, Paige.
David Stewart: And now, Coming Attractions. Each week, we preview commentary that will be appearing in the next issue of the Tax Notes magazines. We're joined by executive editor for commentary, Jasper Smith. Jasper, what do you have for us?
Jasper Smith: In Tax Notes, Mark Hoenig discusses the tax issues stemming from joint ventures between for-profit and tax-exempt entities. And Jasper Howard explains what taxpayers should consider when deciding whether to seek a private letter ruling regarding a spinoff.
In State Tax Notes, John Mikesell discusses how property tax enforcement and collection systems function and how these systems differ across taxing jurisdictions. Also, Thomas Clifford and Richard Anklam discuss New Mexico's long-term budget challenges regarding oil and gas, as well as the state's tax law changes from the 2019 legislative session.
And in Tax Notes International, Yue Dai analyzes China's 2018 individual income tax reform, including how the changes fit with China's unique tax culture and how China's tax system fits into the global tax environment. While Thomas Horst examines financial statements of large U.S. nonfinancial corporations to assess the effect that the TCJA has had on their effective tax rates.
We also want to remind listeners of the June 30 deadline for our student writing competition. For more information, visit taxnotes.com/contest.
David Stewart: You can read all that and a lot more in the May 27 editions of Tax Notes, State Tax Notes, and Tax Notes International.
That's it for this week. You can follow me on Twitter @TaxStew, that's S-T-E-W. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.
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