Inconsistency in state conformity to the Code

Editor: Mary Van Leuven, J.D., LL.M.

State conformity to the federal Internal Revenue Code is not a new topic, but it continues to challenge states and taxpayers whenever Congress amends the Code. This item aims to look beyond the more routine conformity issues and explore some overlooked complexities imposed by state incorporation of the Code. It also highlights recent examples of why paying close attention to the nuances of how states conform to the Code can meaningfully inform taxpayers’ state tax positions.

What is conformity?

The concept of one jurisdiction adopting another’s law — commonly referred to as “incorporation” — is not unique to state adoption of the Code. Voluminous scholarship addresses inter-jurisdictional incorporation of law in both the domestic and international context. While state tax practitioners are familiar with the concept of incorporation (likely under the term “conformity”) as a standard facet of the state income tax landscape, some specific underlying aspects of incorporation of the Code into state law may fly under the radar. These peculiarities posed by broad incorporation of the Code can present more than just academic curiosities.

At its base, incorporation of extraterritorial law by a jurisdiction — including state adoption of the Code — either by specific provision or more broadly, is treated “as if the referenced material were set out verbatim in the referencing statute” (Artistic Entertainment, Inc. v. City of Warner Robins, 331 F. 3d. 1196, 1206 (11th Cir. 2003)). Under this general rule, a state’s adoption of the Code has the effect of writing the entire Code into state law (see Jam v. International Finance Corp., 139 S. Ct. 759 (2019) (stating that a reference statute “in effect cuts and pastes the referenced statute”)). Thus, when a state adopts specific provisions or chapters of the Code for purposes of computing its income tax, that has the effect of rewriting the referenced portion of the Code into state law.

Why do states conform and what are the limitations on conformity?

States generally conform to the Code to simplify the calculation of taxpayers’ income taxes and to make the administration of the state tax system simpler and more efficient. These efficiencies of conformity, however, often butt up against other state policy concerns such as state budgets and state-specific incentives that do not necessarily align with those of the federal government. Further, as Congress inevitably continues to amend the Code, the federal policy goals animating those amendments may change over time, causing states to adjust their conformity to the Code or limit their adoption of future changes.

While all states appear to permit incorporation, they generally provide some limitations on the practice. For example, some states do not allow for dynamic incorporation (i.e., “rolling” conformity) pursuant to anti-delegation provisions contained in their state constitutions, which bar the delegation of legislative power to any persons or bodies other than the state legislature (leading to “static” conformity). Even the desire for administrability does not and seemingly cannot override a prohibition against delegation. Additionally, the desire for administrability does not stop states from decoupling from specific Code provisions for various policy or budgetary reasons.

Even within the specific categories of static or rolling conformity to the Code, the use of varied language in conformity statutes can create complexities. For instance, some static-conformity states adopt the Code “as amended” on a certain date, while other static-conformity states adopt the Code as “in effect” on a certain date. While it may be easy to gloss over these subtle distinctions, the specific words make a difference.

Curious complications of conformity

While determining and tracking state conformity to the Code can present numerous practical issues, substantive issues can arise even after The conformity rule of a given state is determined.

First, a practical concern is issues caused by Congress’s adopting retroactive tax provisions. For example, when the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P. L. 116-136, was enacted in 2020, it amended the treatment of excess business loss deduction limits by suspending them retroactively for 2018 and 2019. The Colorado Department of Revenue (DOR) interpreted its rolling conformity statute to apply only prospectively and denied a taxpayer’s claim for refund filed for 2018 and 2019, applying the CARES Act retroactive amendments. The Colorado Court of Appeals overturned the DOR’s refund denial and held that Colorado’s conformity statute requires conformity to retroactively effective amendments to the Code (Anschutz v. Colorado Dep’t of Rev., 524 P.3d 1203 (Colo. App. 2022) (holding, in part, that Colorado’s conformity statute “includes ‘the provisions of the [Code], as amended … for the taxable year,’ without any limitation as to when any amendment is enacted or goes into effect”)). Other states with conformity statutes that include limitations based on when the amendments to the Code are “in effect” could reach different conclusions as to whether and when retroactive changes to the Code apply for state purposes.

Second, when states decouple from provisions of the Code for policy reasons, it can frustrate the efficiency goal of administrability both directly and indirectly, depending on the way sections of the Code interrelate with each other. For instance, many states decouple from the federal bonus depreciation provisions for budgetary reasons. This decoupling creates significant compliance costs for taxpayers, as it requires taxpayers to maintain multiple depreciation schedules. Because depreciation affects the basis in an asset for purposes of computing gain and loss on the sale of the asset, taxpayers may also have to track both a federal and state basis in depreciable assets for many years, arguably defeating the goal of administrability.

The specific ways in which states decouple from bonus depreciation can create additional complexities. Most states begin the calculation of state taxable income with a taxpayer’s federal taxable income determined under the Code and then make modifications from that starting point. In Michigan, however, the Code is statutorily defined as excluding Sec. 168(k), which provides for bonus depreciation. This distinction makes a difference. Because Michigan adopts a version of the Code without Sec. 168(k), taxpayers must recompute interest limitations under Sec. 163(j) of the Code as if bonus depreciation did not exist. This results in taxpayers’ having to track Michigan-only interest limitations and related carryforwards in years when bonus depreciation affects the calculation of interest limitations for federal purposes.

Third, incorporation can also cause complexities and hinder the goal of administrability when certain federal concepts are not carved out from a state’s general incorporation of the Code. The complexity caused by such conformity relates to the natural friction between the federal tax regime and some state tax regimes. For example, issues can arise when states that require taxpayers to file on a separate-entity basis adopt an unmodified provision of the Code that is adjusted for federal purposes due to a taxpayer’s consolidated filing at the federal level.

For example, the regulations under Sec. 385 treat members of a federal consolidated group as one corporation for purposes of the debt-equity recharacterization rules codified at Regs. Sec. 1.385-3. This “one corporation” treatment may not carry over to separate-return states. Therefore, it is possible that an indebtedness could be recharacterized under the federal Sec. 385 regulations as equity for state purposes while no such recharacterization would occur for federal purposes under the consolidated one-corporation fiction. Similar complexities arise in the context of the Sec. 163(j) limitation when it is computed on a consolidated-group basis for federal purposes but on a separate-entity basis in separate-company (and some combined-return) states.

Finally, there is also the issue of states, through general adoption of the Code, incorporating provisions they are likely prohibited from adopting as original legislation. For instance, in Beatrice Cheese v. Wisconsin Department of Revenue, the Wisconsin Tax Appeals Commission determined that a Wisconsin law disallowing accelerated depreciation under federal accelerated cost recovery system rules for property located out of the state while allowing accelerated depreciation for in-state property violated the Commerce Clause by discriminating against business done outside Wisconsin (Beatrice Cheese, Inc. v. Wisconsin Dep’t of Rev., Nos. 91-I-100, 91-I-102 (Wis. Tax App. Comm’n 2/24/93)). The commission found that the effect of this differential treatment was to impose a higher franchise tax burden on a business solely because its depreciable property was located outside Wisconsin. Similarly, in R.J. Reynolds Tobacco Co. V. City of New York Department of Finance, the Appellate Division of the New York Supreme Court found that a New York City ordinance discriminated against out-of-state property holders in violation of the Commerce Clause because it disallowed an accelerated depreciation deduction for a corporation’s property placed in service outside New York, while allowing such a deduction for property located in New York (R.J. Reynolds Tobacco Co. V. City of New York Dep’t of Fin., 237 A. D.2d 6 (N.Y. App. Div. 1997)).

Courts have also held that discriminatory tax provisions adopted by reference similarly violate the Commerce Clause. In Kraft General Foods, Inc. v. Iowa Department of Revenue and Finance, 505 U.S. 71 (1992), the U.S. Supreme Court held that Iowa’s corporate income tax unconstitutionally discriminated against foreign commerce because it “impose[d] a burden on foreign subsidiaries that it [did] not impose on domestic subsidiaries.” Specifically, through its conformity to the Code, Iowa disallowed a deduction for dividends received from foreign subsidiaries but allowed a deduction for dividends received from similarly situated domestic subsidiaries, which discriminated against foreign commerce.

Notwithstanding the relevant case law, states have broadly adopted the version of Sec. 174 amended by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, which discriminates against foreign commerce in favor of domestic commerce. In fact, the House Ways and Means Committee report for the TCJA states that Congress intended that “research and experimentation expenditures that are attributable to research conducted outside of the United States should be amortized over a longer period so as to encourage research and experimental activities inside the United States” (H.R. Rep’t No. 115-409, 115th Cong., 1st Sess., at 282 (2017)). While Congress is free to discriminate against foreign commerce via its power to regulate such activity under the Commerce Clause, state adoption and application of such rules — either as original legislation or by reference — would seem to violate the Commerce Clause, similar to the discriminatory provisions addressed in Kraft, Beatrice Cheese, and R.J. Reynolds Tobacco.

More changes ahead

Undoubtedly, Congress will continue to make changes to the Code to achieve policy goals that will shift over time. As of this writing, a bill is being considered by the 118th Congress that would amend the treatment of certain research and experimental expenses retroactively (H.R. 7024). The application of these provisions and others sure to be seen in the future will require states and taxpayers to look closely at whether, when, and how states, through their conformity to the Code, will apply those changes. The state tax amounts related to these changes can be substantial, making familiarity with state conformity to the Code critical.

Editor notes

Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C. Contributors are members of or associated with KPMG LLP. For additional information about these items, contact Van Leuven at mvanleuven@kpmg.com.