The devil is in the details and currently the federal tax reform proposals are more theoretical than detailed. However, the common theme of the proposals seems to be territorial, taxing imports, encouraging repatriation of foreign earnings by reducing the rate of tax on those earnings, and stimulating the expansion of domestic manufacturing by expensing cost recovery. The proposals would cut the corporate tax rate to compensate for the expansion of the federal tax base.
Most states conform to federal taxable income and use it as the starting point for the calculation of taxable business income subject to apportionment. The manner in which the states conform generally take one of three basic approaches:
- piggyback the Internal Revenue Code;
- take a static approach and adopt the code as of a specific date; or
- adopt only specific provisions of the code.
The fundamental question is will the states adopt some or all of the proposed changes, or decouple from the changes as numerous states have done in the past? In either instance, a state legislative effort is likely to be required, which will allow local interests to potentially influence the ultimate outcome. What may prove beneficial for federal tax purposes may not be beneficial at the state level.
The federal proposals broaden the tax base but then offset some of the impact of that broader base with a reduction in the corporate rates. At the state level, the starting point in most cases would be the broader tax base but there is no link between the state corporate tax rate and the federal rate. As a result, the states have the potential for a windfall without a real incentive to reduce the state corporate rate. That windfall may be partially mitigated by some unique state tax issues resulting from the proposals. Drilling down into some of the actual proposals gives rise to numerous issues at the state level that may not have a federal counterpart. For example, will the repatriation of foreign earnings be characterized as dividends? At the federal level, only in very limited circumstances would the funds qualify for a dividends received deduction. The various federal proposals would tax this income at a significantly lower rate. The states, however, are required to treat foreign and domestic dividends the same. The repatriated funds, if characterized as a dividend, should be subject to the state dividends received deduction. The repatriation issue becomes more complex in those states that allow or require a worldwide combined return. To the extent the earnings of the foreign entity have been included in the worldwide return, those earnings have been included in taxable income and taxed in a prior year. As a result, a specific subtraction modification may be required to avoid the potential for double taxation. Another example of the complexity that may result from federal tax reform is the fact that at the federal level there is no characterization of income. However, for state corporate income tax purposes, it must be determined if the income is apportionable business income or allocable nonbusiness income, thus increasing or decreasing the state tax base. The characterization of the income may not only affect the computation of the state tax base but also may affect the computation of the formula used to apportion that tax base as well.
The destination-based cash flow tax (for example, border adjustment) raises some interesting issues with respect to the impact on existing tax treaties, World Trade Organization requirements, and the economic viability of a tax structure that picks winners and losers. While the mechanism for implementing this type of tax structure has not been defined, it appears to place a significantly higher tax on products, services, and intangibles that are brought into the U.S. regardless of where they are manufactured. From a state tax perspective, how would this border tax adjustment be classified? Is this a tax that is imposed or measured by net income? Most states deny a deduction for income taxes. However, if structured as an indirect tax that is imposed for the privilege of importing goods, services, or intangibles, it may be deductible for state purposes. Yes, the devil is in the details.