Last week, as the proposed border-adjusted tax on imports died, state and local tax practitioners from around the country met at the annual Georgetown Advanced State and Local Tax Institute, where one topic dominated conversations and presentations: federal tax reform. One of the questions posed was how might the June 24, 2016, GOP tax reform blueprint and President Trump’s April 26, 2017, tax reform proposal affect corporate income tax among states?
Internal Revenue Code (IRC) Conformity
Most state corporate income tax codes are built around the federal corporate income tax code. When calculating state corporate income tax, the majority of states begin with federal taxable income and then require to taxpayers to make certain additions and subtractions to arrive at the company’s state tax liability. If that federal “starting point” is affected by federal tax reform, state tax revenues will undoubtedly be affected.
States could react to federal tax reform and the lowering of the corporate income tax by adjusting modifications to the federal tax base, often called “decoupling” from the IRC. The issue is further complicated by the fact that states have different approaches of conforming to the federal tax code, with some conforming on an ongoing basis while others conform to the federal tax code as it was on a specific date.
Full Expensing of Capital Assets
Currently, businesses recover the cost of capital investments such as buildings, equipment, and even livestock over the life of the investment, which could take decades. It can take decades to recover the cost of the investments and taxpayers must follow certain rules for enhanced asset expensing.
The GOP blueprint and the Trump proposal replace the current asset expensing system with “full expensing” of capital investments for the year in which they are purchased, though the Trump proposal provides an alternative option of deducting net interest expenses. While this will allow businesses to pay lower taxes, they will lose the net interest expense deduction.
Elimination of Net Interest Expense Deduction and NOL Carryforward Limitation
Currently, businesses can deduct net interest expenses from federal taxable income as it is incurred. The GOP blueprint allows for deductions only against net interest expenses for future loans while Trump’s proposal permits taxpayers to choose between the aforementioned full expensing of capital assets and the net interest expense deduction.
Specifically, the GOP blueprint allows for net interest expenses to be carried forward indefinitely and allowed as a deduction against net interest income in future years. Notably, the blueprint also allows for “net operating losses to be carried forward indefinitely and… increased by an interest factor that compensates for inflation and… return on capital." Currently, the federal tax code allows 20 years for an NOL carryforward.
Territorial Taxation from Worldwide Taxation
Currently, businesses are required to report worldwide income on their federal tax returns and are subject to tax on dividends and other payments. The GOP and Trump proposals move to a territorial system where dividends from foreign subsidiaries are fully exempt from U.S. taxation. This change will likely have a minimal effect on state tax revenue.
If federal tax reform happens, states will react in different ways. Some may make minimal changes to try and preserve the status quo on the state level. Some may put “triggers” in place that bring in more revenue at a certain point in time. Some may seek out alternative income such as gross receipts taxes or franchise taxes. With many states experiencing fiscal challenges and some states being affected more than others by federal tax reform, there are sure to be changes on the states level if federal tax reform comes to pass.
Continue the discussion on LinkedIn: What has your state done to prepare for the potential federal tax reform?
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