While some of the international tax provisions set forth in the current federal tax bill are complex from a federal tax perspective, layering on state tax implications adds not only another layer of complexity, but also much uncertainty concerning the potential treatment of such provisions for state tax purposes. This analysis focuses on the implications of the repatriation transition tax (Repatriation Transition Tax) provisions and the global intangible low-taxed income (GILTI Tax) provisions.
Repatriation Transition Tax
The Repatriation Transition Tax, as set forth in the tax bill, imposes a tax on certain foreign earnings that have traditionally not been subject to federal income tax, albeit at a lower rate than the general corporate tax rate. Under the new law, accumulated foreign earnings held by CFCs of a US shareholder will be deemed repatriated and taxed federally at a rate of 15.5 percent if attributable to cash or cash equivalents and at a rate of 8 percent if attributable to illiquid assets. The taxpayer may then elect to pay the resulting federal income tax liability over an eight-year period.
To fully understand the state tax implications of the Repatriation Transition Tax, it is advisable to understand the mechanics of the Tax. The Repatriation Transition Tax has the following three components:
- The taxpayer increases the amount of its taxable income included under IRC section 951(a) to reflect the deferred foreign earnings and profits (E&P) of its controlled foreign corporations (CFCs) (RTT Addition).
- The taxpayer takes a deduction under section 965 equal to an amount that would result in the taxpayer being subject to tax at a rate of 8 percent on the amount by which its RTT Addition exceeds its aggregate foreign cash position, plus an amount that would result in the taxpayer being subject to a tax rate of 15.5 percent on the amount of the taxpayer’s aggregate foreign cash position that does not exceed the taxpayer’s RTT Addition (collectively, the RTT Deduction).
- The taxpayer can elect to defer payment of the Repatriation Transition Tax liability by paying the liability in eight installments, each of which is computed based on a percentage of the Repatriation Transition Tax liability.
RTT Addition: Since states generally use federal taxable income as the starting point for their state income tax bases, the RTT Addition included in federal taxable income under Internal Revenue Code (IRC) section 951(a) should automatically result in an increase to that state tax base unless the state has a specific exclusion for such income. For example, some states provide an explicit exclusion for certain income received from CFCs, while other states treat the income as a dividend eligible for a dividend-received deduction. Some states, however, would include the income from the RTT Addition in determining the state tax base either because they do not provide a dividend-received deduction or because they do not consider income from a CFC that is included in a taxpayer’s federal taxable income pursuant to IRC section 951(a) to be a dividend.
The Deduction: In some states, whether or not the RTT Deduction is included in determining the state tax base may depend upon whether the RTT Deduction is considered a “special deduction” for federal income tax purposes. More specifically, some states specify that the starting point for determining a taxpayer’s state tax base is federal taxable income before any special deductions have been taken. The IRC describes special deductions as those deductions set forth in Part VIII of the IRC. Accordingly, the RTT Deduction should not be considered a special deduction because it is imposed by IRC section 965, which is not in Part VIII of the IRC.
It should be noted, however, that in 2005 the Internal Revenue Service (IRS) did include the section 965 temporary dividend-received deduction related to repatriated dividends as a special deduction on Form 1120, even though section 965 is not in Part VIII. Even if the RTT Deduction is similarly reflected on the federal tax return as a special deduction, this placement should not cause the RTT Deduction to actually be a special deduction because placement of an item on a federal tax return should not overrule the statutory language provided by the IRC. Thus, if a state specifies that the starting point for its state tax base is federal taxable income before special deductions, the better argument seems to be that the RTT Deduction should be included in determining the state tax base, whether or not the IRS reflects the RTT Deduction as a special deduction on Form 1120. Please note that if a statute specifies that the starting point in determining the state tax base is income as reported on Line 28 of the taxpayer’s Federal 1120 (instead of specifying that the starting point is taxable income prior to the deduction of special deductions), the placement of the RTT Deduction on the Federal 1120 could become much more important.
In states where the RTT Deduction is included in determining the starting point of a taxpayer’s state tax base, there may be no specific state modification that would apply to addback the RTT Deduction to the tax base unless the state has a specific reference to IRC section 965 or if the RTT Deduction is deemed a dividend-received deduction (or unless, of course, the state law is amended). To the extent that a state provides a deduction or exclusion for the RTT Addition as a dividend but does not exclude the RTT Deduction in determining the taxpayer’s state tax base, a taxpayer could end up with a windfall. However, it seems likely that such states would take the position that the RTT Deduction is a dividend-received deduction that must be added back under any dividend received deduction provision.
Deferral of Tax Payment: The potential election to defer payment of the Repatriation Transition Tax liability would likely not be effective in most, if not all, jurisdictions because the deferral is implemented not by deferring the recognition of the taxpayer’s federal taxable income—which might result in a change in the taxpayer’s state tax base—but by merely deferring the time for payment of the taxpayer’s federal income tax liability. Thus, absent specific legislative changes by the states, all state tax liability or benefit resulting from the Repatriation Transition Tax would likely be required to be paid or recognized in the 2017 tax year.
Repatriation Transition Tax Summary Conclusion: For states that do not provide an exclusion for income received from CFCs under IRC section 951(a), the effective net inclusion of the RTT Addition and the RTT Deduction in the states’ tax base should be the same as the net amount included in federal taxable income, although there would probably not be any ability to defer the cash/payment impact over eight years unless the states change their laws to allow for such deferral. Accordingly, due to the substantial amount of income that may be included as part of the Repatriation Transition Tax, even when netted by the RTT Deduction, a constitutional issue (factor representation/fair apportionment) may arise in states that do not include the factors of the CFCs that generate the income in determining the taxpayer’s apportionment formula. While this issue concerning unconstitutionality may exist under the current CFC-income inclusion rules, it would be even more critical with respect to amounts included under the Repatriation Transition Tax because the amount of the increase in the tax base from the Repatriation Transition Tax may be very substantial and, thus, exclusion of the CFCs’ factors in a taxpayer’s apportionment formula could create substantial distortion.
On the other hand, in those states that do provide for an exclusion of CFC income, taxpayers may be able to exclude the RTT Addition but still be entitled to the RTT Deduction. Taxpayers in these states could potentially end up with a windfall. To avoid this taxpayer windfall, it appears likely that the impacted states would attempt to construe the RTT Deduction as a dividend-received deduction that should be added back. This argument could be compelling because otherwise there would be a phantom “loss” included in computing the taxpayer’s state tax base.
Furthermore, it should be noted that this analysis concerns the potential treatment of the Repatriation Transition Tax under the current state tax laws. Assuming the federal tax reform bill is enacted, we expect that many states will enact legislation to adapt their tax laws to address the components of federal tax reform. For example, it is likely that states in which taxpayers may possibly generate a windfall under the current state laws will change their laws to avoid that result.
The tax bill also provides for the global intangible low-taxed income tax, which is being referred to as the GILTI Tax. The GILTI Tax is a tax on a US shareholder’s share of its CFCs’ global intangible low-taxed income at a reduced effective rate of 10.5 percent (13.125 percent beginning in 2026). The GILTI Tax is intended to tax a portion of the CFCs’ active (non-Subpart F) income—that portion equal to the excess of an implied 10 percent rate of return on the CFCs’ adjusted bases in tangible depreciable property used to generate the active income.
As with the Repatriation Transition Tax, the GILTI Tax does not merely include certain items in the tax base, but instead includes both an addition and a smaller deduction to essentially achieve the desired reduced effective tax rate. The GILTI Tax thus consists of the following two components:
- The taxpayer includes the GILTI of its CFCs in its taxable income under newly added section 951A (not 951(a)) (GILTI Addition); and
- The taxpayer takes a deduction under new IRC section 250 equal to, at most, 50 percent of the GILTI Addition plus any corresponding section 78 gross-up plus, at most, 37.5 percent of the taxpayer’s foreign-derived intangible income (combined, these three components comprise the GILTI Deduction).
GILTI Addition: Since states generally use federal taxable income as the starting point for their state income tax bases, the GILTI Addition should automatically result in an increase to the state tax base unless the state has a specific exclusion that could apply to the GILTI payments. For example, there may be a position that the Subpart F income received from the CFC is a dividend such that the GILTI payment is excluded in states that have specific exclusions for dividends. Note, however, that since section 951A would be a new Internal Revenue Code section, there would be no authority determining whether the GILTI Addition is a dividend and, since it is not computed based on a corporation’s E&P, it is not clear how this issue would ultimately be decided.
Furthermore, if the GILTI Addition is included in the state tax base, a taxpayer could also take the position that factor representation mandates inclusion of a portion of the CFCs’ receipts in the receipts factor.
The GILTI Deduction: The GILTI Deduction is provided for in IRC section 250, which is in Part VIII of the IRC and, thus, is a special deduction for federal income tax purposes. Because the GILTI Deduction is a special deduction, whether it will be included in the state tax base in a jurisdiction depends on whether the starting point for taxable income in such jurisdiction is federal taxable income before or after special deductions. In states where the starting point is federal taxable income after special deductions have been taken, the net GILTI Tax inclusion should be the same as it would be for federal income tax purposes, absent a specific state modification. In states where the starting point is federal taxable income before special deductions, the taxpayer would be required to include the GILTI Addition in taxable income but would not be entitled to the GILTI Deduction, absent a specific state modification.
GILTI Tax Summary Conclusion: For states that do not have an exclusion that could apply to the GILTI Addition and the GILTI Deduction, the effective net inclusion in the state’s tax base should be equal to the net amount included in federal taxable income. However, in certain states the entire amount of the GILTI Addition may be included in the state tax base with no corresponding offset for the GILTI Deduction. The constitutional factor-representation issues will become even more critical in such states as the amount of income included could be more substantial and, thus, potentially more distortive.
Furthermore, it should be noted that this analysis concerns the potential treatment of the GILTI under the current state tax laws. Assuming the federal tax reform bill is enacted, we expect that many states will enact legislation to adapt their tax laws to address the components of federal tax reform. We expect that taxpayers will seek to encourage states that include the GILTI Addition in the tax base but do not allow for the GILTI Deduction to change their laws.
In determining the proper state tax treatment of the Repatriation Transition Tax and the GILTI Tax, taxpayers must analyze both the IRC implementation language and the language in the state’s statutes. Due to the differing language used by the states to exempt dividends and income received from CFCs, it is likely that the Repatriation Transition Tax and the GILTI Tax will have diverse impacts in different states. These issues should be monitored carefully as it is expected that many states will change their laws to address these issues directly.
Please contact us if you would like to discuss the state tax impact of the Repatriation Transition Tax or the GILTI Tax.