The State Taxation of Foreign Source Income: Planning, Compliance, and Constitutional Challenges Post-Federal Tax Reform

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1 The State Taxation of Foreign Source Income: Planning, Compliance, and Constitutional Challenges Post-Federal Tax Reform PRESENTERS: ALYSSE MCLOUGHLIN, MCDERMOTT WILL & EMERY, NEW YORK, NY JEFFREY VESELY, PILLSBURY WINTHROP SHAW PITTMAN, SAN FRANCISCO, CA MODERATOR: FERDINAND HOGROIAN, COST SPRING AUDIT SESSION/INCOME TAX CONFERENCE BOSTON, MASSACHUSETTS APRIL 19, 2018 Council On State Taxation

2 AGENDA Repatriation Global Intangible Low-Taxed Income (GILTI) Foreign Derived Intangible Income (FDII) Base Erosion Anti-Abuse Tax (BEAT) Interest Deductibility 2

3 Repatriation 3

4 REPATRIATION (IRC 951(a), 965(a), 965(c)) Federal rule: Post-1986 E&P of foreign subsidiaries included in income: IRC 965(a). Partial deduction to lower effective tax rate on inclusion: IRC 965(c). 4

5 REPATRIATION: STATE IMPACT Conformity? Timing, consequence under state law. IRC 965(a) IRC 965(c) Relevance of statutory dividends received deduction (DRD) provisions. Unclear whether 951(a) income is a dividend for federal income tax purposes. If it is generally, pre-1987 E&P deficit could reduce the amount of the 965(a) income that is a dividend. States may treat 965(a) income as a dividend for state DRD purposes regardless of federal treatment. Potential constitutional issues should these receipts be included in the apportionment formula? 5

6 REPATRIATION: TAX RETURN ISSUES Separate form for reporting tax on deemed foreign earnings. Stand-alone form, not a schedule to a Form Separate payment required to be made. 6

7 DEEMED REPATRIATION: CALIFORNIA ISSUES California does not currently conform to IRC 965. Subpart F income means Subpart F income as defined in IRC 952. RTC 25110(a)(2)(B)(i). Inclusion ratio numerator not affected by IRC 965 amendments; denominator is the current year E&P as defined under IRC 964. If IRC 965 affected the inclusion ratio, there would be a mismatch, since new IRC 965 references accumulated earnings, not current E&P. Effect of RTC

8 ACTUAL REPATRIATION: CALIFORNIA ISSUES California does not conform to IRC 245A. Deduction of dividends depends on whether filing on a worldwide or water s-edge basis. Dividend elimination under RTC % dividends received deduction under RTC Foreign investment interest offset under RTC Inclusion ratio issues with respect to Subpart F income. Are the dividends business or nonbusiness income? RTC 25110(b)(2)(B) presumption. 8

9 ACTUAL REPATRIATION: CALIFORNIA ISSUES Sales factor reflection. Should the dividends be included in the sales factor? FTB Legal Ruling Regulation sourcing rules. Effect of Regulation 25137(c)(1)(A). Distortion and factor representation issues. Earnings and profits issues. California and federal differences. Ordering of dividends. Deferred intercompany stock account issues. 9

10 REPATRIATION: NEW YORK RESPONSE New York s Budget Bill expanded the statutory provisions to ensure that deemed repatriated foreign earnings are excluded from the tax base. Expanded to include amounts from non-unitary corporations. The general interest attribution rules apply. Either attribution or 40% of excluded income. 10

11 REPATRIATION: TENNESSEE RESPONSE Important Notice No , TN Dep t of Rev., April This guidance provided that, due to the separate form provided by the IRS for the reporting of the deemed repatriated foreign earnings and the fact that the deemed repatriated foreign earnings are not reported on line 28 of the federal form, such income is excluded from the tax base. Incorrect rationale? What about financial statements? 11

12 REPATRIATION: OREGON RESPONSE Oregon S.B (signed by the Governor) Provides that the gross, not the net repatriation amount is included in the tax base, with such gross amount subject to the dividendsreceived deduction of 70 or 80 percent, depending upon level of ownership. Ensures that taxpayers don t receive double deduction. Repeals tax haven law Under tax haven law (ORS ), Oregon may already have taxed some of the income now deemed repatriated. To alleviate any double taxation, new Section 33 in the bill allows a credit for taxes attributable to this income. The credit is limited to the lesser of the tax attributed to the repatriated income or the tax on the income included under ORS Unused credits may be carried over 5 years. 12

13 Global Intangible Low-Taxed Income (GILTI) 13

14 GILTI (GLOBAL INTANGIBLE LOW-TAXED INCOME) Purpose: to discourage U.S. companies from moving business operations to low-tax foreign countries. Federal rule: U.S. corporation must include in income certain income of a foreign corporation affiliate that is taxed abroad at a rate lower than the U.S. rate and that exceeds a 10% return on the affiliate s tangible property. IRC 951A. U.S. parent can deduct 50% of its GILTI (thereby reducing the effective tax rate on it). IRC 250(a)(1)(B). Partial foreign tax credit allowed to lessen tax imposed on GILTI in an effort to tax only income generated in low-tax jurisdictions. 14

15 GILTI: STATE IMPACT Conformity? Consequence under state law. IRC 951A IRC 250 Relevance of statutory DRD provisions. Potential constitutional issues should these receipts be included in the apportionment formula? 15

16 GILTI: CALIFORNIA IMPACT California does not conform to IRC 951A. Depends on whether filing worldwide or water sedge. No changes to IRC 952. No effect on numerator of inclusion ratio. IRC 951A(c)(2)(B)(ii) discussion of tested loss. Potential effect on denominator of inclusion ratio. Federal/California basis and E&P differences. 16

17 GILTI: NEW YORK RESPONSE New York s Budget Bill did not address GILTI. The GILTI addition and deduction are included in the starting point of the tax base. A DRD is available only if GILTI is a dividend. Is GILTI a dividend for federal purposes? Is GILTI a dividend for New York purposes? 17

18 GILTI: GEORGIA RESPONSE Georgia H.B. 918 (enacted on March 2, 2018) This conformity bill did not provide for any exclusion from the tax base for GILTI, although the IRC 250 deduction was allowed. In addition, the bill provided that the Georgia DRD did not apply to GILTI. Georgia S.B. 328 (enacted on March 26, 2018) Due to pressure from the business community, this bill provided that GILTI was treated as Subpart F income and excluded from the tax base. NOTE: Wisconsin A.B. 259 (enacted April 3, 2018) also decoupled from GILTI, although the State was already decoupled from all of Subpart F. 18

19 Foreign Derived Intangible Income (FDII) 19

20 FOREIGN DERIVED INTANGIBLE INCOME (FDII) (IRC 250(A)(1)(A)) Federal rule: Purpose: The FDII deduction is intended to reduce the incentive to move operations abroad by lowering the tax on income from sales by U.S. companies to foreign buyers. This is done by providing a deduction for income above a 10% return on tangible property (excluding certain income such as subpart F income). 20

21 FDII: STATE IMPACT States may feel that they don t need to provide an added incentive to that provided by the U.S. Companies that would not otherwise stay in the U.S. because the federal incentive is not enough also may not decide to stay because of a state incentive. States that conform to federal taxable income would have to affirmatively decouple. The FDII deduction is a special deduction under IRC Several states now decouple from special deductions. Such a state would have to amend its statute to allow the FDII deduction. 21

22 FDII: CALIFORNIA AND NEW YORK California does not conform to IRC 250 Treatment of foreign derived intangible income depends on whether filing worldwide or water s edge. New York s Budget Bill decoupled from the FDII deduction. 22

23 Base Erosion Anti- Abuse Tax (BEAT) 23

24 BASE EROSION ANTI-ABUSE TAX (BEAT) Purpose: to prevent shifting income to foreign countries. The BEAT is based on taxable income, but deductions for certain payments to foreign affiliates are disallowed. The BEAT is a federal alternative minimum tax. It does not increase taxable income. 24

25 BEAT: STATE IMPACT States that use federal taxable income as a base will not automatically conform to the BEAT because it does not adjust federal taxable income. Many states already have an AMT. Why add a new one? States may see this as a revenue raising opportunity. Will states apply the concept to payments to affiliates in other states? The BEAT applies only to corporations with gross receipts of $500 million or more. States could apply it to smaller companies. Constitutional problems. 25

26 Interest Deductibility 26

27 NET INTEREST EXPENSE LIMITATION (IRC 163(J)) Federal rule: Limits deduction to net interest expense that exceeds 30% of adjusted taxable income (ATI) plus business interest income. Initially, ATI is computed without regard to depreciation, amortization, or depletion. Beginning in 2022, ATI will be decreased by those items. 27

28 Interest Expense Limitation: California Issues California conforms to prior version of IRC 163(j). No automatic conformity to amendments to IRC 163(j). Compare RTC FTB attempts to apply former IRC 163(j). California has two expense attribution-type statutes that are applied to interest deductions. RTC expenses disallowed where they were incurred for the primary purpose of producing nontaxable income. RTC Foreign investment interest offset: interest expense incurred for the purposes of foreign investment may be disallowed. 28

29 Questions? ALYSSE MCLOUGHLIN, (212) JEFFREY M. VESELY, (415)