Federal Destination-Based Tax System Would Pressure States

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By Che Odom

States might have a difficult time maintaining their corporate income tax structures if the federal government follows a House plan to move to a destination-based cash-flow tax system.

States would lose “all the coordination and enforcement mechanisms and the information sharing” available to them by being in harmony with the federal government, Harley Duncan, tax managing director of state and local tax at KPMG LLP, said May 19 at a National Tax Association meeting.

“That makes their job more difficult,” he said. And companies would expect states to follow the federal approach.

House Republicans released a tax reform plan in June 2016 that would lower marginal tax rates and expand the base on the individual income tax side. It also would lower the corporate income tax rate to 20 percent and make changes to the base.

For example, it would change the corporate income tax to what is called a destination-based cash-flow tax. Under the plan, businesses would fully expense their capital investments rather than depreciate them over a number of years or decades. Businesses would no longer be able to deduct their net interest expense against their taxable income.

Additionally, foreign profits would no longer be subject to domestic taxation, and the corporate income tax would be destination-based, meaning that the plan would make the U.S. income tax border-adjustable, according to the plan.

Radical Changes

These are radical changes that state may not be willing to follow, Duncan said. Some will want to maintain a net income tax instead of moving to destination-based system in order to preserve revenue, he added.

“I think it is an open question whether states could sustain a net income tax in the face of a destination cash-flow tax,” he said.

Multistate corporations also could feel pinched if the federal government moved to destination-based taxation because with about 40 different regimes at the state level, compliance is already expensive, he said.

Still, domestic and foreign business taxpayers will expect states to follow the destination-based approach and to lower rates given the broadening of the base of what’s taxed, Duncan said. Many states won’t want to lower rates.

Border Adjustments

Another wrinkle is that states could run afoul of the U.S. Constitution by going along with the border adjustment plan advocated by House Speaker Paul D. Ryan (R-Wis.) but opposed by key Senate Republicans.

Generally, border adjustment would call for taxing imports while exempting exports.

States such as California, New York, and Texas that require combined or unitary reporting of business income—which counts income from all business units inside and outside the state—could find border adjustments a complicated matter.

The problem is the foreign commerce clause and the U.S. Supreme Court’s 1992 ruling in Kraft Gen. Foods Inc. v. Iowa Dep’t of Revenue and Fin., Steve Wlodychak, a principal at Ernst & Young LLP who focuses on state, local, and federal tax issues, told Bloomberg BNA.

“As I read that ruling, states can’t discriminate in the tax treatment of foreign companies, and that goes even if the state merely follows the federal treatment of a transaction,” Wlodychak said.

‘Kraft’ Decision

In Kraft, Iowa required the taxpayer to report taxable income based on an Internal Revenue Code section that excluded foreign dividends from a deduction. Iowa’s conformity to the code meant that it also taxed foreign dividends, but not those received from domestic companies.

“The same principle should theoretically apply to border adjustments,” Wlodychak said. “Inputs from foreign companies would not be deductible while inputs from U.S. domestic companies would.”

To contact the reporter on this story: Che Odom in Washington at COdom@bna.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bna.com

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