Corporate Close-Up: Kentucky’s Tax Overhaul Shifts the Corporate Tax Landscape as We Know It

Last month Kentucky overrode Gov. Matt Bevin’s (R) veto of a two-year operating budget (H.B. 200) and a tax reform bill (H.B. 366), a move that will result in an estimated tax increase of $400 million. Interestingly enough, the day after Bevin’s veto was overridden, H.B. 200 and H.B. 366 were superseded in part by H.B. 265 and H.B. 487, mostly featuring cleanup of the original bills, plus the surprising 11th hour introduction of mandatory combined reporting. Because Bevin let the 10-day sign or veto period lapse, Kentucky was able to pass sweeping tax reform.

Most notably, Kentucky updated: their federal conformity date; instituted a flat corporate tax rate; adopted a single-sales factor apportionment formula and market-based sourcing of services and intangibles; and last, but certainly not least, mandated combined reporting for unitary groups.

Federal Conformity

Kentucky now conforms to the Internal Revenue Code as it existed on Dec. 31, 2017, for tax years beginning on or after Jan. 1, 2018. Allowing the state to conform to Pub. L. No. 115-97, excluding specific enumerated provisions, but not to the tax extender provisions seen in the Bipartisan Budget Act of 2018.

For tax years beginning prior to Jan. 1, 2018, Kentucky’s federal conformity date remains December 31, 2015.

Corporate Tax Rate

Kentucky now has a flat corporate tax rate of 5 percent. This flat rate replaces Kentucky’s three-bracket corporate income tax rate schedule, which featured a top tax rate of 6 percent.

Single Sales Factor Apportionment

Kentucky has adopted a single-sales factor apportionment formula for all industries except communications service providers, cable service providers, and internet access providers. As a result of the formulary single-sales factor, all business income is apportioned to Kentucky by multiplying income by a fraction (the numerator of which is the taxpayer’s total receipts in Kentucky during the taxable year, and the denominator of which is the taxpayer’s total receipts everywhere during the taxable year).

This shift away from the three-factor apportionment formula (whether evenly weighted or double-weighted sales) has been increasingly popular with state legislatures as it has been linked to increased in-state jobs and investments due to the reduction in the tax burden on in-state businesses with a larger physical presence. Multistate corporate taxpayers in general are less sanguine about the impact of single-sales on their state income tax liability.

Market-Based Sourcing

Kentucky now has market-based sales factor sourcing for sales of intangible personal property (e.g., software) and services. As a result, receipts from the sale, rental, lease, or license of intangible property and the sale of services are generally sourced to Kentucky if the taxpayer’s market for the sale is in the state. A taxpayer’s market for a service is generally considered to be in Kentucky if the service is delivered to a location within the state. A taxpayer’s market for software and other intangible personal property is generally considered to be Kentucky if it is licensed, rented, or leased within the state; while the sale of a contractual right or license to sell a taxpayer’s intangible property is considered to be in Kentucky if any part of the geographic region assigned is in Kentucky. Kentucky excludes sales of intangible property and services from the sales factor if the sourcing cannot be reasonably estimated.

Kentucky’s move away from cost-of-performance sales factor sourcing for services and intangibles, by which sales are sourced to the state where the greatest income-producing activity occurs, follows the popular trend amongst an increasing number of states.

Mandatory Combined Reporting

In addition, Kentucky requires water’s-edge combined reporting for tax years beginning on or after Jan. 1, 2019. The water's-edge combined group includes members that are doing business in certain tax havens and members that are not 80/20 companies. Each member of the combined group is responsible for its share of total taxable income earned throughout the contiguous United States. A combined group’s total income is determined as if the members were not consolidated for federal purposes. Total income is the sum of each member’s federal taxable income adjusted for Kentucky additions and subtractions. If a corporation is a member of a pass-through entity the group must add back any I.R.C. § 199A deduction taken for qualified business income from a pass-through entity. Further, net operating losses are not shared among members of the combined group and are computed on a post-apportionment basis.

Kentucky also permits an affiliated group to elect to file a state consolidated return, whether or not the group files a federal consolidated return, in lieu of filing the combined report. The election to file a Kentucky consolidated return is binding on both the revenue department and the affiliated group for eight years. Kentucky’s mandatory combined reporting is a dramatic shift away from the state’s mandatory nexus consolidated reporting rules; a move that is historically considered to be the most effective way to combat corporate tax avoidance.

Tune in for Bloomberg’s tax reform webinar on Wednesday, May 30, 2018, from 2 pm to 3 pm. “Federal Tax Reform: State Impact and Responses” will give you a snapshot of state responses to federal tax reform and let you know what to expect during the remainder of the year. Register for this webinar here.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: How does Kentucky’s tax overhaul affect practitioners or the bottom line for taxpayers?

For more information on the impact of Pub. L. No. 115-97, examine Bloomberg Tax’s Tax Reform Roadmap, showing detailed comparisons between pre-reform law and impending changes, with pertinent cites attached.

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