Editor: Mark Heroux, J.D.
It has been more than nine months since the enactment of P.L. 115-97, the law known as the Tax Cuts and Jobs Act (TCJA), and states' reactions to tax reform are still being reported. In the past year, numerous articles have been written about potential and theoretical implications of deemed repatriation under the new provisions of Sec. 965. This discussion takes this thinking a step further by identifying new trends in states' conformity with or decoupling from Sec. 965.
Federal points to consider
The TCJA, under Sec. 965(a), provides that post-1986 accumulated foreign earnings and profits (E&P) of specified foreign corporations, measured by the greater of accumulated E&P as of Nov. 2, 2017, or Dec. 31, 2017, will be subject to a mandatory repatriation tax through an income inclusion in the 10% or more U.S. shareholder's Subpart F income for calendar-year taxpayers in 2017. Sec. 965(c) provides for a separate deduction that ensures deemed income inclusions of E&P held in the form of cash and cash equivalents will be taxed at an effective rate of 15.5% and E&P attributable to illiquid assets will be taxed at an effective rate of 8%. The TCJA permits an election to pay the tax in installments over eight years. Elections under Sec. 965 may be made by the extended due date for filing the relevant tax return. However, taxpayers electing to pay their repatriation tax liability in installments under Sec. 965(h) must make the first installment payment by the unextended due date of their return for the inclusion year.
States' reaction to Sec. 965
A state's reaction to Sec. 965 depends on its method of conformity to the Internal Revenue Code. As of now, most states conformed or decoupled from Sec. 965 in the following ways:
Rolling conformity: States automatically adopt the current Code as it is updated and revised, unless the state has preexisting law that provides for decoupling from specific Code provisions. For instance, Massachusetts generally follows the Code as amended and in effect for the tax year (Mass. Gen. Laws. ch. 63, §§1 and 30). Thus, corporations that have "federal gross income attributable to Code § 965 must also report that income" for Massachusetts excise tax purposes (Mass. Dep't of Rev. TIR 18-4, Estimated Tax Penalty Relief for Corporations Affected by the Transition Tax on Deferred Foreign Earnings (May 15, 2018)). Other examples of rolling conformity jurisdictions include the District of Columbia and Illinois.
Annual conformity: States adopt the Code as of a certain date (e.g., Dec. 31, 2017) and generally do so affirmatively on an annual basis. For example, in Virginia, H.B. 154, signed into law on Feb. 23, 2018, provides that Virginia conforms to the Code as of Feb. 9, 2018, with an exception for any provision of the TCJA that affects the computation of federal taxable income of corporations for tax years beginning after Dec. 31, 2016, and before Jan. 1, 2018. As such, Virginia conforms to Sec. 965 as it affects the computation of federal taxable income of corporations for tax years beginning Jan. 1, 2018. Other examples of annual conformity states include Florida, Georgia, and Iowa.
Fixed conformity: At the end of their 2018 legislative sessions, states will affirmatively adopt the Code, including select or all provisions of the TCJA. States that do not update their conformity date as of the TCJA's enactment decouple from the new provisions, unless noted otherwise. For instance, California conforms to the Code as of Jan. 1, 2015 (Cal. Rev. & Tax. Code §23051.5(a)(1)), and per guidance issued by the Franchise Tax Board, California decouples from Sec. 965. Taxpayers that reported income derived because of Sec. 965 on the federal return are requested to write "IRC 965" on top of their California tax return and make adjustments to their return (Cal. Franchise Tax Bd., California Guidance — Taxable Year 2017 IRC Section 965 Reporting (May 22, 2018)). From a practical perspective, it may take some of these states several years to adopt the Code as of Dec. 31, 2017. For instance, the last date of conformity for Texas is Jan. 1, 2007 (Tex. Tax Code §171.0001(9)).
Selective conformity: Certain states will continue to follow or decouple from specific Code sections as they have historically. For instance, Pennsylvania, which refers to the mandatory deemed repatriation under Sec. 965 as the repatriation transition tax (RTT), subjects it to Pennsylvania's corporate net income tax because the RTT is part of federal taxable income. However, Pennsylvania considers the RTT deduction under Sec. 965(c) to be included in determining the Pennsylvania state tax base, resulting in net RTT income. Pennsylvania treats net RTT income as Subpart F income and permits use of Pennsylvania's dividends-received deduction rules to reduce the Pennsylvania tax base before apportionment (Penn. Dep't of Rev., Information Notice, Corporation Taxes and Personal Income Tax — 2018-1 (April 20, 2018)).
States have also been considering whether mandatory deemed repatriation income is included in the sales factor of the apportionment formula. In its guidance, Pennsylvania provides that no portion of RTT income is included in the sales factor because RTT income is treated as a dividend for corporate net income tax, and dividends are excluded from the sales factor (Penn. Dep't of Rev., Information Notice, Corporation Taxes and Personal Income Tax — 2018-1 (April 20, 2018)). Similarly, Tennessee provides that deemed repatriated income should not be included in its apportionment formula (Tenn. Important Notice, No. 18-05 (April 1, 2018)). Other states, such as Alabama, are still considering potential apportionment implications of Sec. 965 (Ala. Dep't of Rev., Notice: IRC Section 965 — Guidance for Corporate Filers, Partnerships, S Corporations, and Individual Taxpayers (April 27, 2018)). If the mandatory deemed repatriation income is included in the sales factor, then state sourcing rules should be considered.
Sec. 965(h) installment payments
Most states decoupled from the Sec. 965(h) installment payment provisions. For instance, Rhode Island notes that the Sec. 965(h) election does not defer recognition of income and thus "Section 965 income, in its entirety, is recognized and must be included on a taxpayer's federal return for its last taxable year beginning before January 1, 2018" (R.I. Dep't of Rev. Advisory 2018-21 (April 25, 2018)). Similarly, Illinois notes that it does not allow the Sec. 965(h) election (Ill. Dep't of Rev., 2017 Illinois Income Tax Guidance — Foreign Income Repatriation Transition Tax (March 2018)).
As another example, Pennsylvania provides that Sec. 965(h) does not apply for Pennsylvania corporate net income tax purposes, with the exception of real estate investment trusts (REITs) that elect to defer income inclusions under Sec. 965(m) over an eight-year period. In those circumstances, REITs' net repatriation income, i.e., repatriation income reduced by an allowed deduction, will be included in Pennsylvania corporate net income as those amounts are subject to federal income tax (Penn. Dep't of Rev., Information Notice, Corporation Taxes and Personal Income Tax — 2018-1 (April 20, 2018)).
Disallowance of the installment election may result in financial hardship and additional compliance burdens on taxpayers. However, as of now, only Oklahoma and Utah conform to Sec. 965(h), allowing taxpayers to pay their repatriation tax liability in installments (Okla. Stat. §2368(K); Utah Code Ann. §59-7-118).
Personal income tax considerations
A state providing exclusion of deemed repatriation income for corporate income tax purposes might still tax that income under personal income tax provisions. For instance, in response to the TCJA, New Jersey issued guidance stating that "the deemed repatriation dividends will be excluded from entire net income" to the extent the corporation owns 80% or more of a subsidiary (N.J. Div. of Tax. Notice, New Jersey's Treatment of Deemed Repatriation Dividends Reported Pursuant to Internal Revenue Code (IRC) Section 965 (March 16, 2018)). However, for New Jersey gross income tax, which applies to individuals and estates and trusts, the same guidance provides that deemed repatriation dividends "are an enumerated category of income" and "must be included in New Jersey gross income in the same tax year and in the same amount as reported for federal purposes" (N.J. Div. of Tax. Notice, New Jersey's Treatment of Deemed Repatriation Dividends Reported Pursuant to Internal Revenue Code (IRC) Section 965 (March 16, 2018)).
The deferral provisions allowed under federal law may not extend to the state level. For instance, Illinois, New York, and Rhode Island noted that shareholders of an S corporation cannot defer payment of their tax liability until some triggering event under Sec. 965(i) (Ill. Dep't of Rev., 2017 Illinois Income Tax Guidance — Foreign Income Repatriation Transition Tax (March 2018); N.Y. Dep't of Tax. and Fin. N-18-4, New York's Treatment of IRC § 965 Repatriation Income for Individuals for Tax Year 2017 (April 2018); (R.I. Dep't of Rev. Advisory 2018-21 (April 25, 2018)).
Many states were caught off guard by certain TCJA provisions. The majority of guidance concerning the application of Sec. 965 was published around the time when original returns were due for calendar-year taxpayers or shortly thereafter. Taxpayers that filed their 2017 tax returns but received state guidance thereafter may face new compliance obligations. For instance, California requires taxpayers who reported Sec. 965 amounts on their 2017 tax return to amend the return and remove Sec. 965 amounts (Cal. Franchise Tax Bd., California Guidance — Taxable Year 2017 IRC Section 965 Reporting (May 22, 2018)). While in California such an exclusion may generate a refund, in other states, such as Illinois, a failure to include Sec. 965 net income could result in penalties and interest and, if that income was not included on the original returns, taxpayers are mandated to report the income on amended returns (Ill. Dep't of Rev., 2017 Illinois Income Tax Guidance — Foreign Income Repatriation Transition Tax (March 2018)).
With the goals of efficient tax administration and easing any compliance burdens due to the change in a law, a few states announced their intentions to waive any estimated tax penalties from underpayments attributable to Sec. 965. For instance, Massachusetts announced that to claim a waiver of penalties "a taxpayer must include Massachusetts Schedule M-2220, Underpayment of Massachusetts Estimated Tax by Corporations, with its return, accompanied by Massachusetts Schedule TDS, Taxpayer Disclosure Statement, identifying the amount of federal gross income attributable to Code § 965 as well as any explanation of the Schedule M-2220 calculation" (Mass. Dep't of Rev. TIR 18-4: Estimated Tax Penalty Relief for Corporations Affected by the Transition Tax on Deferred Foreign Earnings (May 15, 2018)). New York pronounced that issuance of the TCJA "so late in the 2017 taxable year constitutes reasonable cause" for an underpayment of personal income tax liability attributable to Sec. 965 (N.Y. Dep't of Tax. and Fin. N-18-4, New York's Treatment of IRC § 965 Repatriation Income for Individuals for Tax Year 2017 (April 2018)).
Be mindful of state rules
Taxpayers should not ignore state income tax issues on mandatory deemed repatriation under Sec. 965. As this discussion highlights, states do not have a standardized approach for dealing with Sec. 965 concepts. Instead, a state may either conform to or decouple from Sec. 965 provisions, reduce the effect of inclusion by not imposing tax on Subpart F income, or, through dividends-received deductions, allow or disallow an installment payment election under Sec. 965(h), and allow or disallow deferral under Sec. 965(i). Talking to a tax professional with substantial knowledge in this area and performing a state-by-state analysis should identify opportunities where mandatory deemed repatriation income would not be taxed on a state level, or pinpoint means for reporting, apportioning, and taxing that income appropriately, thus reducing the potential for penalties and interest for noncompliance.
Mark Heroux, J.D., is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.