On December 22, 2017, the TCJA was signed into law. It made sweeping changes to the federal tax structure, affecting both individuals and corporations. More importantly from a corporate perspective, the enactment of the TCJA resulted in a significant shift in both domestic and foreign tax policy. The result was a movement from the taxation of U.S. corporations on their worldwide income to one of a territorial taxation structure; for example, taxing domestic-source income while excluding from taxation most earnings from foreign subsidiaries. For those of us who have spent the majority of our careers in the SALT world, this should sound familiar, because most states have adopted a similar approach of taxing only domestic-source income. Although the goal of the TCJA may have been to move the federal tax scheme to a territorial-based one, several provisions were designed to tax the earnings of foreign subsidiaries. The application or adoption of these provisions at the state level has raised numerous policy and legal concerns. The federal policy reasons for these TCJA provisions appear to fall within one of two broad categories. The first is to generate additional revenue to offset the revenue loss resulting from other provisions of the TCJA. The second is to combat the perceived notion of federal tax base erosion. These policy reasons do not necessarily carry over to the states, as it has not been shown that there are state revenue losses resulting from the TCJA that need to be offset. To the extent there is erosion of the state tax base there are statutory or regulatory mechanisms in place to resolve it.
The GILTI regime31 is one of three TCJA provisions designed to encourage domestic commerce by penalizing domestic corporations doing business in low-tax foreign countries. It is also the provision that has raised a significant amount of discussion and concern at the state level. Specifically, should the states adopt GILTI, and if adopted, will it pass constitutional muster? For federal tax purposes a low-tax country is one with a tax rate of 13.125 percent or lower. Essentially, under the federal scheme a tax rate of 10.5 percent will be imposed on 50 percent32 of GILTI and an 80 percent FTC may be taken against the remaining income. First, it is highly unlikely the states will tax GILTI at a lower rate. Second, the vast majority of states, do not provide for FTCs. Thus, the mitigating provisions found at the federal level do not carry over to the states. The result for the states could be a revenue windfall and a likely legal challenge.
While the rationale for GILTI may work at the federal level, its adoption at the state level raises several issues and concerns. Before the enactment of the TCJA, most states evaluated and developed policy regarding whether to include foreign-source income in the tax base. The result of that evaluation was the enactment of water's-edge reporting, a deduction for foreign dividends, the exclusion of subpart F income and section 78 gross-up, as well as the inclusion of the income of foreign entities that have more than 20 percent of their property and payroll in the United States. Thus, except for the few states that continue to require or allow worldwide combined reporting, most state tax schemes have adopted a territorial approach. To tax GILTI appears to turn those policy decisions on their ear. This is particularly true for those states that automatically conform to the IRC because these new provisions are clearly inconsistent with long-stated policy.
More importantly, there are legal concerns with the adoption of the GILTI regime. There are several constitutional constraints placed on a state's ability to impose a tax that are not imposed at the federal level. First, a state must have jurisdiction to tax the income, and that taxation must not violate either the commerce clause or the foreign commerce clause. Second, if the state does have jurisdiction, that income must be fairly apportioned to the state. There is a serious question if the state taxation of GILTI would pass constitutional muster. The governing principle in the U.S. Supreme Court's decision in Kraft33 was that a state may not treat foreign operations less favorably than a similarly situated domestic operation. The Court noted that the commerce clause is not violated when the different tax treatment of two categories of companies results solely from the different nature of those business activities and not the location of the business activities. The issue with GILTI is twofold. First, a domestic corporation is not taxed on deemed income from a domestic subsidiary. However, that same domestic corporation would be taxed on the deemed income of a foreign subsidiary. Furthermore, the computation of GILTI is fundamentally different from the computation of a domestic company's income. Thus, one is not dealing with the different treatment resulting from the nature of the business activities, but rather the different treatment is based solely on the location of those business activities. This differential treatment violates the principles enunciated by the Court in Kraft. Assuming, for sake of argument, the taxation of GILTI will pass foreign commerce clause muster, the income must be fairly apportioned. There must be some recognition given in the apportionment formula to the income-generating factors. To fail to provide for some factor representation opens the taxing jurisdiction up to a challenge based on the fact that income is being taxed out of all proportion to the business activity in the state. What is appropriate factor representation is open to debate, and is complicated by multitiered foreign entities, the treatment of the section 250 deduction, and states' own definition of "gross receipts."
"Should States Embrace Gilti?" constructed by J?anne Rauch-Zender was published in State Tax Notes, (Volume 91, Number 11) March 18, 2019 for its subscribers. Read the full article here.
31GILTI is not just intangible income. The formula for calculating GILTI includes a reduction for a normal return (10 percent) on the taxpayer's intangible property at its depreciated value. In theory this should exclude a portion of the entity's income that is attributable to tangible property. Issues arise for a capital-intensive business with older depreciated facilities as well as businesses that have little capital investment, such as service or financial businesses.
32Section 250 provides for a 50 percent deduction of GILTI.
33Kraft, 505 U.S. 71.