Business Tax Reform – A State and Local Perspective
As with any federal tax legislation, the state tax implications are often far-reaching and can take some time to develop. From a personal tax standpoint, state tax calculations are generally independent from federal ones. Thus, rate reductions and exemption/deduction limits will likely have little direct impact on personal income taxes at the state level.
From a corporate tax standpoint, many states start with federal income and then add specific state adjustments. In these instances, the federal concepts are generally incorporated by reference to the Internal Revenue Code (the “Code”). However, while some states incorporate the Code on a rolling basis for each year, others incorporate the Code as of a specific date. Thus, even if a state conforms to the Code, it may not conform to the Code in its current form.
The specifics of the current framework are still in the early stages and subject to speculation. The following provisions may initially have the most direct impact at the state level:
- Expensing capital investments;
- Limiting interest deductions; and
- Repatriating foreign income, including transitioning to a territorial tax system.
Expensing Capital Investments
States have been reluctant to conform to federal accelerated depreciation provisions in the past, and considering current state budget deficits, states are unlikely to conform to immediate expensing in the short term. One potential taxpayer benefit is they may only need to calculate depreciation at the state level, forgoing federal calculations. This should simplify the depreciation addbacks at the state level, at least minimally. There may be an opportunity for some states that wish to increase local capital investments (e.g., via headquarters relocation/site development) to conform to the federal provisions.
Limiting Interest Deductions and Repatriation of Foreign Income, Including Transition to a Territorial Tax System
From a SALT (and a business) perspective, these ramifications are interlinked.
When deductions for interest payments are limited, the cost of debt financing increases accordingly. Thus, many companies will likely rely less on debt and more on equity or internal cash flows to fund projects. Companies repatriating large amounts of income that are currently parked overseas will likely consider utilizing these funds for projects that may have otherwise been funded with outside debt. Both opportunities and pitfalls may exist at the state level, however.
Such projects are often funded via an intercompany debt arrangement. Assuming both the lender and borrower are part of a consolidated return at the federal level, these transactions are eliminated. This would negate the limits on interest deductions at the federal level as well as in most combined state filings. However, many states still require separate company filings utilizing a federal pro forma return. For those states that incorporate federal tax concepts by reference, some borrowers may find their interest deductions limited at the state level. Conversely, some lenders may see inflated tax bills due to additional interest income resulting from those intercompany lending activities.
Lenders may be able to establish intercompany financing subsidiaries in low (or no) tax jurisdictions, such as Delaware or Nevada, possibly resurrecting the “intangible holding company” planning structure.
Borrowers should review their major states for Code conformity and the potential application of addback provisions for interest paid to related members. Some states may only require an addback where an amount is deducted for federal purposes and then allow for an addback exemption under certain conditions. Here is one potential pitfall:
State X conforms to the current version of the Code by utilizing federal line 28 as a starting point. It requires an addback of interest paid to related members where such amounts were deducted for federal purposes. State X also provides for an exception to the addback of interest if it meets certain conditions. Taxpayers may have relied on one of these exceptions in State X to deduct this interest for State X purposes. However, if there technically is no interest addback since it is already limited at the federal level, does the addback exception apply?
Further, one common addback exception pertains to amounts paid to members in foreign countries that have a tax treaty with the U.S. Where companies convert foreign debt to U.S. debt, this addback exception may now be inapplicable. Companies should review their intercompany debt arrangements closely if they are being altered in any way.
Finally, when large amounts of money will be repatriated via dividends, companies should know that many states have decoupled their dividends-received deduction (“DRD”) from the federal provisions. Thus, they may find that dividends that are deducted from income at the federal level may not be subject to a similar DRD at the state level. Companies should review the applicable state DRD provisions prior to bringing these amounts back to the U.S. in order to identify and avoid any DRD pitfalls at the state level.