David Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Worldwide Tax Daily. This week: The state responses to the Tax Cuts and Jobs Act. Since state tax systems are affected by, and in some cases linked, to the federal income tax system, the TCJA has created a number of challenges for state policymakers. To talk about how they are responding, we are joined by State Tax Notes Chief Correspondent Amy Hamilton. Amy, welcome to the podcast.
Amy Hamilton: Thanks for having me.
David Stewart: Let's start out with a brief overview. Where do things stand in the states now that the TCJA is in place?
Amy Hamilton: Well, most of the mainstream headlines to date have focused on the new $10,000 limit on the federal deduction for state and local taxes, the so-called SALT cap. But the TCJA also contains several business tax provisions, both domestic and international. According to the National Conference of State Legislatures, understanding the impact of these changes has been quite a challenge for state policymakers. It's requiring a truly state-by-state analysis. So on the business side, what we’ve seen this session are state lawmakers focusing primarily on whether to conform or to decouple from various provisions of the TCJA. Experts expect most of the state legislative action to take place in the next 18 months, and for policy debate to loom large in the states for at least the next four or five years.
David Stewart: Since it is the most headline grabbing part, let's start with the state and local income tax deduction. What is happening there?
Amy Hamilton: That probably would be a federal story, were it not for the reaction by states with higher taxes and high-net-worth individuals. Before, a taxpayer who itemized could claim any state and local taxes paid on their federal return. When the cap was enacted, leaders in a handful of blue states called the cap a form of economic civil war. They believe the Republican-controlled federal government targeted Democratic states with this cap to help pay for the federal reform.
David Stewart: As I understand it, states are both threatening to sue the federal government, and enacting so-called workarounds for the cap. Is that right?
Amy Hamilton: Correct. New York, New Jersey, and Connecticut in January formed a coalition to challenge the new cap. Maryland has since joined. They recently filed their suit. They're asking a federal court in New York to declare the cap unconstitutional, and for an injunction blocking its enforcement.
David Stewart: What are their arguments?
Amy Hamilton: They’re saying a SALT deduction has been part of every federal income tax since the first one was enacted and that it ensures the federal power to tax does not interfere with state sovereignty. The argument is that by increasing the federal tax burden on individuals who pay the most in state taxes, the cap will make it harder for these states to maintain their own tax and fiscal policies. Another part of this is that some administration officials and members of Congress flat out said the cap was intended to send the message to high-tax states that they need to change their choices. The states are citing these comments as proof that the cap was meant to coerce a handful of states to change their policies to what the federal government would prefer.
David Stewart: Now the state tax deduction workaround that I've heard most about is a charitable deduction. What is that?
Amy Hamilton: A dozen states this session proposed such a workaround. Basically, this would take advantage of the fact the TCJA did not cap the deduction for charitable contributions. Details vary by state, but the idea is that states would allow individuals to essentially make payments in lieu of state taxes to a variety of state-operated charitable funds. In theory, individuals could fully deduct that payment as a charitable contribution for federal tax purposes while at the same time satisfying their state and local tax liabilities.
David Stewart: That seems a bit weird, and I understand that Treasury Secretary Steven Mnuchin has called it ridiculous.
Amy Hamilton: He did, and the IRS and Treasury in May announced they're going to be issuing guidance on these ways of circumventing the cap. The proposed regulations apparently will make clear that the Internal Revenue Code’s requirements are informed by substance over form and that federal law controls the characterization of these payments. So, Treasury and the IRS also indicated they're keeping an eye on other forms of SALT workarounds.
David Stewart: What other workarounds are there?
Amy Hamilton: New York would shift from a personal income tax system to a payroll tax system. This would take advantage of the fact that businesses can fully deduct a state employer payroll tax on their federal returns. Another SALT workaround was first enacted by Connecticut. This involves moving to taxing passthroughs at the entity level, while providing an offsetting personal income tax credit for the entity's members. New York recently released its own draft proposal for a statewide entity level tax on passthroughs and said it was specifically in response to the TCJA.
David Stewart: Since we're already talking about passthroughs, let's talk about the impact on state business taxes. Specifically, I'm thinking about the section 199A deduction on passthrough entities enacted in the TCJA. Is that a factor for the states?
Amy Hamilton: Interestingly enough, that appears to be one of the few provisions that Congress changed at the last minute, specifically with the states in mind. A senior tax counsel for the Senate Finance Committee's Republican staff said this spring that the conference committee decided at the last minute that the deduction under section 199A would not be allowed in computing adjusted gross income. Instead, the deduction would reduce taxable income. Senators made that switch after a governor's office expressed concern about the revenue impact on states using AGI as the starting point for calculating taxable income.
David Stewart: What does the switch mean for the states?
Amy Hamilton: By making the passthrough deduction under the determination of taxable income, rather than the calculation of AGI, this means that most states will not automatically conform to the deduction. Before, they would have. Instead, the change now affects only a handful of states, the ones that tied the start of their personal income tax calculation to the federal taxable income.
David Stewart: If you would, could you walk us through the other key domestic provisions, and whether the states are expected to conform with them or to decouple from them?
Amy Hamilton: Sure. Some of the information I'm providing is coming from EY and the Council On State Taxation, and some is coming from attorneys at the Multistate Tax Commission. As you know, at the federal level the TCJA reduced the corporate income tax rate from 35 percent to 21 percent. States don't conform to federal rate changes. There has, however, been a business push for states to either reduce their own corporate income tax rate, or to at least not turn around and attempt to tax any windfall that corporations get from receiving a tax break at the federal level. Experts generally expect very limited state conformity to 100 percent bonus depreciation. States are expected to largely conform to the new federal 30 percent limit on interest expense deductions. States likely will vary widely to what extent they'll conform to the new limit on their operating loss deductions. And most states should conform to the amortization of research and experimental expenditures, as well as to the repeal of the federal domestic production deduction.
David Stewart: Now, I'm particularly interested in how states are responding to the TCJA's international provisions. I have to admit, I'm biased. Can we expect major changes in the ways that states treat foreign-source income?
Amy Hamilton: This is shaping up to be a key area to watch, and the debate is already starting to get intense. Should states try to tax repatriated income? Should they conform to a new category of income created by the TCJA, the global intangible low-taxed income, GILTI? What about the new federal BEAT, the base erosion and antiabuse tax? Most states have already chosen not to tax subpart F income, or to tax only a small sliver of it. Because of this, EY estimated that two-thirds to three-quarters of the states should see no increase in corporate tax revenue as a result of the deemed repatriation event. GILTI, meanwhile, that's technically not subpart F income. And so most states that automatically conform to the code would likely include GILTI in their basis. But, there's been a big push by multistate corporations for states to treat GILTI the same as subpart F.
David Stewart: So, therefore, not to tax it?
Amy Hamilton: Correct. Large multistate corporations are arguing that before federal reform, states generally excluded foreign income from their own basis, and that the states should continue with this treatment. This argument to date has been most effective in regard to state treatment of repatriated income. States went into session just days after the TCJA was enacted. The deemed repatriation date occurred in the past, in December 2017. The easiest thing for states to do has been to decouple from the repatriation provisions, and they've done so with little or no debate. But there are people in the field of state taxation arguing that states should consider taxing this income.
David Stewart: So, who are some of these people, and what are their arguments?
Amy Hamilton: Darien Shanske of the UC Davis School of Law is arguing, not only that states should tax repatriated income, but that they should consider conforming to GILTI and even to the new federal BEAT. For example, he's saying that as a matter of federal constitutional law, GILTI should be analyzed as a mechanism to capture domestic income. And thus, it could be included in a state tax base, as long as the apportionment formula is reasonable. He's saying that federal tax reform gives states more, not less, reason to conform to the TCJA's international tax provisions.
Then there's Michael Fatale of the Massachusetts Department of Revenue. He's arguing in public forums that the longstanding subpart F rules in the states were never designed with this type of income in mind. He's arguing that deemed repatriation is not historic subpart F income. And that state approaches to subpart F income were formed by very different considerations in the 1980s and 1990s.
The U.S. Supreme Court in 1992, said it's discriminatory for a separate-entity state to treat corporate taxpayers with foreign-source earnings less favorably than their domestic counterparts. It's worth noting that state advocates point out that the court, in a footnote, said that it would be hard-pressed to find the same kind of discrimination for water's-edge combined filing states. Partly due to lobbying by businesses and partly due to a question of whether there was even enough income at stake for states to go down this path, states all but abandoned the taxation of foreign dividends and subpart F income. Michael Fatale has said he is not so sure that a state is foreclosed from considering these issues in their next legislative sessions.
David Stewart: How likely are they to bring it up?
Amy Hamilton: We just saw something unexpected happen in New Jersey in late June. In just two days, both chambers of the Legislature introduced and approved a proposal that would have imposed a 9 percent tax on dividends that were deemed to be repatriated in either 2017 or 2018. This was the first real sign that state legislatures might, indeed, be interested in taxing this kind of revenue. That provision ultimately was stripped, however. It had been part of the revenue component of New Jersey's budget package. But it sure suggests that state debate on the international tax provisions has only just started.
David Stewart: Very interesting. Amy, where can listeners find you online?
Amy Hamilton: I'm on Twitter @alhstn.
David Stewart: Thank you for being here.
Amy Hamilton: Thanks very much.
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 will you have for us?
Jasper Smith: In Tax Notes, Jerred Blanchard Jr. of Baker & McKenzie illustrates how the amount of, and limitations on, the new dividends received deduction of section 245A are determined on a consolidated basis. And Patrick Driessen explains why permitting apportionment of domestic expenses associated with foreign activity remains important, despite how the Tax Cuts and Jobs Act has been interpreted by some.
In State Tax Notes, professors Adam Thimmesch, Darien Shanske, and David Gamage begin a series of articles aimed at evaluating the U.S. Supreme Court's opinion in South Dakota v. Wayfair. The first article in this series tackles some of the more immediate interpretive questions raised by the Wayfair opinion, such as how a state should approach substantial nexus. Also, Eric Coffill of Pillsbury interviews Nicolas Maduros, director of the California Department of Tax and Fee Administration.
And in Tax Notes International, Professor Phelippe de Oliveira, of the Queen Mary University of London, argues that a recent decision by the Brazilian Superior Court of Justice misinterpreted Article 24 of the Brazil-Sweden tax treaty and should be reversed.
As well, authors from Moodys Gartner considered the effect U.S. tax reform changes may have on Canada regarding both U.S. inbound and outbound investment.
David Stewart: You can read all that and a lot more in the July 30th 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 at us at podcast@taxanalysts.org. Be sure to subscribe to us on iTunes or Google Play to make sure you get the next episode of Tax Notes Talk.
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