Obama tax: State income tax issues and consequences of the Obama administration's proposed international tax revisions

The U.S. Treasury Department released its "Greenbook" in May 2009, setting forth the tax proposals contained in President Obama's FY 2010 budget, and in September 2009, the Joint Committee on Taxation issued a report on these proposals. This Multistate Tax Alert identifies three proposed international tax changes that are most likely to have a significant state income tax impact and summarizes what that impact might be. These proposals are referred to throughout this Multistate Tax Alert as:
- Deferred Deductions or the Deduction Deferral Provision
- Foreign Entity Rules
- Repeal of the "80/20 Company" Exception

Details have not yet been given by the Treasury Department for these international tax proposals. Therefore, in projecting state income tax issues and consequences, it is necessary to speculate to some degree as to how the proposed provisions may actually work.


Deferred deductions

Of the three Obama Administration proposals mentioned above, deferred deductions would appear to be the most widely applicable. Under this proposed law change, U.S. corporate taxpayers would be required to defer expense deductions related to foreign income until the income is repatriated. State adoption of this provision could result in deferral of expenses attributable to foreign subsidiaries, while expenses attributable to domestic subsidiaries remain currently deductible. In some states, this discrepancy would appear to violate the Foreign Commerce Clause of the U.S. Constitution as interpreted by the U.S. Supreme Court in Kraft v. Iowa Department of Revenue, 505 U.S. 71 (1992).

In Kraft, the state of Iowa conformed to IRC §243, which generally allows a dividend received deduction for dividends paid by domestic, but not foreign, corporations. Citing the Foreign Commerce Clause of the U.S. Constitution, the Supreme Court held that Iowa could not tax a U.S. corporate taxpayer's dividends from foreign subsidiaries, since the state's tax law allowed a deduction for dividends from U.S. domestic subsidiaries. A similar rationale may apply to a state's conformity to the proposed federal deduction deferral rules, which would operate to defer deductions attributable to foreign, but not domestic, corporations. Some state court cases have found that the Kraft rule does not apply where domestic combined apportionment is used for corporate income tax purposes
because the income from domestic affiliates included in the return is currently taxable. Thus, this constitutional law issue is not likely to impact all states equally. However, at least with respect to taxpayers filing in separate reporting states that conform to this proposed law change, there may be opportunities to raise the issue.

To the extent that deduction deferral does pass constitutional scrutiny in particular states, the state income tax effects may be more complicated than the federal to determine.4 For example, while deferred deductions for federal income tax purposes would generally increase consolidated taxable income, for state tax purposes the same increase to taxable income will have to be allocated to specific corporations and may be taxable at a separate entity level in some states and at various consolidated or combined levels in other states. Furthermore, the valuation of deferred deductions in the multistate income tax environment can be affected by a number of factors that are not relevant for federal purposes, including: (i) changes in apportionment rules or the adoption of combined reporting in particular states, and (ii) changes in operations that alter a particular corporation's apportionment to a given state. These changes can alter the level of apportionment against which a deferred deduction might be evaluated in a particular state.


Foreign entity rules

Under the proposed change to the foreign entity rules, a single-member foreign entity that would currently be eligible for disregarded entity treatment in accordance with the check-the-box rules would be treated as a corporation for federal purposes, unless that entity was created or organized in the same foreign country as its single owner. On the other hand, in the absence of federal tax avoidance, a foreign eligible entity owned by a U.S. corporation could still be a disregarded entity under the proposed change.

It is anticipated that this change would cause an increase in subpart F income. That increase is not likely to produce a significant detrimental state income tax effect for most U.S. taxpayers, as most states provide a deduction or subtraction modification for "deemed dividends" included by a U.S. corporate income taxpayer in its federal taxable income by reason of having an interest in a controlled foreign corporation that has Subpart F income. However, an indirect state tax detriment could result from the intersection of the check-the-box entity classification rules with the 80/20 unitary business group exclusion rules in various states.

The term "80/20 corporation" in state income tax parlance refers to a corporation that is excluded from state water's-edge combined returns, because 80% or more of some apportionment-based measure of business activity is outside the United States. Most states have conformed to the federal entity classification rules, and often the foreign operations included in 80/20 corporations are held in one or more disregarded foreign eligible entities. Where the foreign disregarded entity is directly owned by a U.S. corporation, the changes to the foreign entity rules should generally have no effect. In more complicated structures, where some or all of the foreign operations of the 80/20 corporation are owned in lower tier foreign eligible entities, the proposed rule change could cause a lower tier foreign eligible entity to be treated as a corporation, thus removing that entity's business activity from the 80/20 calculation. As a result, the 80/20 corporation could have inadequate foreign operations to maintain its 80/20 status. Corporate tax departments will have to be mindful of this potential issue.


Repeal of the "80/20 Company" Exception

Under current federal income tax law, interest or dividends that are not effectively connected to the conduct of a U.S. trade or business and that are paid by a U.S. corporation to a foreign corporation are generally subject to a 30% U.S. tax, which is enforced by a withholding requirement on the payor. The Obama Administration proposes to repeal the so-called "80/20 company" exception to these tax and withholding requirements. Under that exception as it currently operates, tax and withholding do not apply if the U.S. corporation paying the interest or dividend has 80% or more of its gross income from "active foreign business income." Because there is no analogue in the state income tax system to either the 30% U.S. withholding tax or to the federal "80/20 company" exception, the proposed repeal of that exception should not have any direct state income tax effect. However, the repeal of the federal exception may potentially have an indirect effect on taxation in Michigan and Wisconsin. Both states have recently added unitary business group provisions that borrow from the federal "80/20 company" rules to define corporations that would be excluded from the unitary business group. If this federal 80/20 company exception is repealed, there is a risk that taxpayers will become less diligent in monitoring that test since there would no longer be any applicable federal benefit. The failure to monitor the 80/20 requirements after the repeal of the federal provisions could result in unexpected changes in taxpayer combined reports for Michigan and Wisconsin purposes.

As more specifics become known about the above-described Obama Administration proposals to revise the international tax provisions of the Internal Revenue Code, we will be able to refine our analysis of the state income tax effects.