State Tax Haven Legislation: Many Proposals But Few Enactments

The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.

By Karl Frieden and Ferdinand Hogroian

Karl Frieden is Vice President/General Counsel for COST. Ferdinand Hogroian is Senior Tax & Legislative Counsel for COST.

With the release of the Organization of Economic Cooperation & Development (OECD) Base Erosion and Profit Shifting (BEPS) project reports in October 2015, global attention has been focused on international income tax rules as applied to multinational businesses. In particular, the OECD reports focus on gaps and mismatches between individual country rules and propose new international tax rules to address the problems of base erosion and profit shifting. At the state level, the debate over foreign source income has primarily centered on the adoption or consideration of tax haven legislation. For the first time since the 1980s, when states pulled back from mandatory worldwide combination, many states are showing serious interest in expanding unitary taxation beyond the U.S. border (known as water's edge). In this selective version of worldwide combined reporting, income inclusion only extends to foreign affiliates either incorporated in or doing business in tax haven nations. Ironically, the proposed state solution constitutes a go-it-alone approach largely inconsistent with the legislative and regulatory solutions being considered and adopted elsewhere in the world.

The drawbacks of state tax haven legislation are detailed in our recently released State Tax Research Institute (STRI) report State Tax Haven Legislation: A Misguided Approach to a Global Issue: 1) there is no clear evidence that profit shifting to tax havens is eroding the state corporate tax base; 2) state tax haven blacklists are arbitrary and unmanageable; and 3) states adopting tax haven legislation risk losing investments and jobs and face constitutional challenges.1 The STRI report provides detailed information about state tax haven legislation and explains why many state legislatures appear to be approaching the issue with initial enthusiasm, followed by growing trepidation.

No Clear Evidence of State Corporate Base Erosion

During the last fifteen years—allegedly the peak period of corporate base erosion and profit shifting—the overall share of state and local taxes paid by businesses actually increased from 42.6 percent (FY 2000) to 45 percent (FY 2014). Drilling down to the corporate income tax (and other replacement business activity taxes), these taxes also have contributed a relatively stable share of all state and local taxes paid by business, primarily ebbing and flowing with the cycles of the U.S. economy. It is perhaps not surprising, therefore, that revenue loss estimates made by proponents of state tax haven legislation have been grossly inflated, significantly above the states' own revenue estimates for similar proposals.

State Tax Haven Blacklists Are Arbitrary and Unmanageable

From a practical perspective, state tax haven blacklists are arbitrary and unmanageable. Initially, state blacklists were based on a list of countries designated as tax havens by the OECD. However, the OECD lists were maintained not for tax base expansion, but for purposes of effective information exchange and transparency. Once the countries on the list complied with the then-OECD standards on these issues, they were taken off the list. Ultimately, every country on the initial OECD list was removed. Without U.S. or international guidance, the states have struggled to determine which countries, if any, should be listed as tax haven jurisdictions. Our report details the states' challenges in formulating and updating these lists, as well as with implementing subjective “criteria” to be left to auditors' enforcement.

The difficulty of creating and managing state tax haven lists is reflected by the actions of the Multistate Tax Commission, West Virginia, Connecticut and the District of Columbia—all of which abandoned their state tax haven lists in favor of a less sweeping criteria approach, often with significant restrictions on income inclusion. For instance, the District of Columbia, which has tax haven criteria already in its laws, enacted a state tax haven list as a last minute amendment to its budget process.2 However, facing intense criticism of the arbitrary nature of the list, the District's City Council reversed course and repealed the list.3 The D.C. experience illustrates these subnational jurisdictions are ill-equipped to judge the adequacy of individual nations' tax structures against criteria developed in an entirely different context (the OECD's efforts to increase transparency and information exchange).

Connecticut, in 2015, experienced an outcome very similar to that in D.C. Connecticut adopted unitary combined reporting in 2015, with a delayed 2016 effective date.4 As part of its combined reporting adoption, it required the Department of Revenue Services to produce a tax haven list. However, business reaction to the tax package was extremely negative, and as a result, Connecticut passed amendatory provisions in a December special session, including significant limitations on the tax haven provisions. As part of these changes, the department is no longer required to produce a tax haven list, and further, the legislation protects certain treaty nations (identified in an IRS publication) from ever being deemed a tax haven.

States Adopting Tax Haven Legislation Risk Losing Investment

In the 1980s, mandatory worldwide combined reporting led to the enactment of measures to authorize retaliatory tax treatment against U.S. multinationals. Like worldwide combined reporting, tax haven legislation taxes foreign source income beyond the water's edge and makes no distinction between companies with domestic or foreign parents. Foreign countries have repeatedly and strenuously objected to inclusion in state tax haven lists, sparking fears of a return to retaliatory tax measures. Tax haven legislation also risks business disinvestment and job reductions as this approach is out of sync with both international solutions to taxing foreign source income and the tax policies of the vast majority of other states (including the largest 25 states as measured by population). Finally, tax haven legislation will likely be challenged on U.S. constitutional grounds: state tax haven measures meddle in foreign affairs and international relations, areas the Constitution entrusts solely to the federal government. Should states risk reduced investment and employment for measures that may ultimately be invalidated by the courts? Recent experience appears to suggest the states' legislatures believe the answer is no.

Recent Tax Haven Legislative Proposals

While twelve states considered legislation in 2015 to enact tax haven provisions, no new state (other than Connecticut) actually enacted tax haven provisions. A similar pattern has continued in 2016. Already this year, state tax haven legislation has failed in Colorado and Maine and died with the Legislature's adjournment in Kentucky. In Maine, tax haven language was stripped from L.D. 1634 in a March 10 Senate vote after the bill had emerged from the House. Meanwhile, on March 28, the Colorado Senate Veterans and Military Affairs Committee voted against H.B. 1275, effectively killing the bill for the 2016 session. In Kentucky, combined reporting legislation with tax haven provisions (H.B. 86, H.B. 342) received no action prior to the Legislature's adjournment of the regular session on April 15.

However, several other states have included tax haven language in either combined reporting proposals or tax haven listing proposals (in existing combined reporting states). Hopefully, future state legislative consideration of tax haven bills will recognize that any perceived benefits of such legislation are far outweighed by the costs of such legislation. To the extent a state believes it is not adequately taxing foreign source income that is effectively connected with the state, there are many other tools available (e.g., addback legislation; alternative apportionment) to address the problem with a more targeted solution, without resorting to overly simplistic and overreaching tax haven legislation.

1 See Karl Frieden and Ferdinand Hogroian, State Tax Haven Legislation: A Misguided Approach to a Global Issue, State Tax Research Institute, February 2016, at http://www.cost.org/Page.aspx?id=92484.

2 See 2015 D.C. Act A21-0148.

As of this writing, the repeal was contained in emergency, and then temporary, legislation. The repeal is still pending inclusion in permanent legislation, due to the District's unique congressional review process for legislation.

2015 Conn. Pub. Acts 15-244 (Reg. Sess.).