Tax reform, also known as the Tax Cuts and Jobs Act of 2017 (TCJA), includes a provision that changes which earnings, profits, and deductions owners of controlled foreign corporations (CFCs) must report.
The provision is contained in Internal Revenue Code (IRC) Section 965. It requires the recognition of certain CFC earnings and profits in an owner’s Subpart F income, coupled with deductions that reduce the effective tax rate on the income. The federal tax on this net income is often referred to as the transition tax.
This potentially significant Subpart F adjustment affects federal tax filings and subsequently elevates the importance of analyzing state tax laws regarding the following topics:
- State apportionable income
- Intangibles apportionment
Impact on the Federal Level
Recent IRS guidance makes analysis regarding inclusion of CFC income crucial in state apportionable income and possibly in apportionment factors. Currently, the IRS guidance directs taxpayers to report CFC income and the deductions in specific ways depending on the type of taxpayer. To support the transition tax calculation, taxpayers will include an additional statement—known as the IRC 965 Transition Tax Statement—with their 2017 federal return.
Among other informational items, all taxpayers must report these amounts:
- Income under new IRC Section 965(a)
- Deduction under IRC Section 965(c)
Neither corporations nor pass-through entities will include these adjustments in federal taxable income. Instead, they’ll report the adjustments in the following ways:
- S corporations and partnerships will report the income and the associated deduction on Schedule K.
- Corporations will compute the transition tax and include it separately on Schedule J—the adjustments won’t be included as a component of federal taxable income on Form 1120.
Trusts and individuals must also comply with specific reporting requirements. The IRS has published questions and answers regarding these reporting differences on its website.
Impacts on the State Level
The transition tax adjustments and the manner of reporting elevates the importance of the following elements when analyzing state tax laws:
- State apportionable income
- Intangibles apportionment
Some states have provided specific guidance. Illinois, for example, has notified taxpayers they must include the IRC 965 Transition Tax Statement with their Illinois return. These taxpayers must also include their Subpart F income when determining Illinois-based income, regardless of how the income is reported on their federal return.
However, many other states haven’t yet provided guidance on the adjustments. This means corporate taxpayers must first determine whether a specific state adopts the TCJA’s provisions. Then they must figure out whether the state requires the IRC Section 965(a) addition to income, the IRC Section 965(c) deduction, or both, be incorporated as separate-item adjustments to federal taxable income.
Practitioners reviewing the rules for California, New Mexico, and Oregon, for example, will discover that each state imposes very different rules for reporting income recognized or received pursuant to the transition tax.
State Apportionable Income
These new reporting requirements create an immediate, practical obstacle for corporate taxpayers. Many states direct these taxpayers to begin with their federal taxable income as reported on Form 1120, modified for several state-specific items. Because the transition-tax adjustments are no longer included in federal taxable income, taxpayers must determine whether—and how—to report these adjustments.
It’s important to recognize these adjustments are still a component of taxable income as defined by IRC Section 63, which incorporates all gross income minus the deductions allowed by IRC Chapter 1.
A state that adopts the new provision of the TCJA and defines taxable income with reference to IRC Section 63 may require inclusion of the IRC Section 965 adjustments in a taxpayer’s federal taxable income—even though those adjustments aren’t included in taxable income as presented on Form 1120.
California’s corporate tax law references provisions of the IRC. However, because general conformity is to the IRC as of January 1, 2015, California’s laws don’t incorporate IRC Section 965.
An exception to the general conformity applies to taxpayers that either:
- Made a California water’s-edge election
- Will report Subpart F income from nonunitary foreign affiliates
These taxpayers must engage in a multipart calculation of income and factor inclusions as well as dividend eliminations and subtractions. Any dividends received from the earnings and profits of a unitary foreign affiliate that have been included in a California worldwide combined report or have been partially included in a water’s-edge combined report will be eliminated.
California’s requirements to partially include income and factors of CFCs in a water’s-edge report are normally triggered when a California water’s-edge filer has federal Subpart F income as defined by IRC Section 952.
Because IRC Section 965 deemed dividend income isn’t defined by IRC Section 952, it isn’t considered Subpart F income for purposes of California’s water’s-edge rules. This income therefore doesn’t cause a CFC to be subject to partial inclusion in the water’s-edge combined report.
The federal requirement to pay tax on this foreign income may induce many US shareholders to repatriate the deemed income as actual dividends. This dividend income could then be included in state income subject to specific modifications.
New Mexico conforms to the IRC as amended and qualifies its definition of income by defining income as income upon which federal income tax is calculated for income-tax purposes.
Currently, the federal transition tax appears to be separately calculated and separately stated from federal income tax. Accordingly, taxpayers may be able to support a position that IRC Section 965 income isn’t included in their New Mexico base income for 2017.
Oregon currently conforms to the IRC as of December 31, 2017, including the deemed repatriation income. However, Oregon tax law adds back the federal deduction that reduces the federal effective tax rate as a modification. Oregon defines taxable income as taxable income defined under IRC Chapter 1.
To the extent IRC Section 965 income is included in apportionable income, a corporate taxpayer may have a supportable position that the adjustment or some type of factor relief may be included in its apportionment factor.
As described above, California doesn’t adopt IRC Section 965. However, taxpayers that receive dividend payments from foreign payers may still have dividend income to report on their California returns.
For example, water’s-edge filers may deduct 75% of these foreign dividends, which would leave 25% of the dividends included in their apportionable income. Further eliminations are available if the dividends are paid from earnings and profits that California has previously taxed.
California’s market-sourcing rules provide guidance to taxpayers that receive dividends in Regulation 25136-2(d)(1)(A)(1), which also discusses gross receipts from the sale of goodwill.
Gross receipts are assigned based on the California portion of the assets or sales of the entity sold, depending on whether at least 50% of the assets of the entity sold consist of real and tangible property.
This introduces some ambiguity because dividends aren’t generally received from an entity that’s been sold. However, including dividends in the same section as goodwill indicates California intends to assign receipts from goodwill and dividends in the same manner it assigns receipts from the sale of stock.
If taxpayers repatriate the cash—or if the adjustment is otherwise included in New Mexico income as a dividend—the impact to New Mexico tax varies based on how taxpayers elect to file their New Mexico return.
- Mechanism one. A taxpayer that files as a separate corporate entity may deduct the same portion of its foreign-source dividend the IRC would allow if the payer were a domestic corporation. Dividends included in apportionable income are then subject to apportionment inclusion based on New Mexico’s income-producing activity rules.
- Mechanism two. A taxpayer that doesn’t file a separate New Mexico return isn’t allowed a dividend subtraction. However, New Mexico does allow limited factor relief, computed using the Detroit formula.
Several years ago, the city of Detroit, Michigan, and Ford Motor Company developed a formula allowing a parent entity to increase its apportionment-factor denominators by the dividend payer’s denominators, multiplied by the percentage—up to 100%—that the dividend bears to the affiliate’s net profits.
A major weakness of the Detroit formula is that it includes only the affiliate’s current-year apportionment factors, although the 2017 deemed repatriation may comprise several years’ worth of earnings and profits.
For years beginning on or after January 1, 2018, Oregon has made key changes to its tax law including:
- Restricting the sales factor to receipts from transactions and activity occurring in the regular course of a taxpayer’s trade or business by incorporating the Multistate Tax Commission’s definition of sales
- Broadening its definition of apportionable income to include any income apportionable under the US Constitution
These laws could be interpreted as including foreign dividends in apportionable income while excluding them from the sales factor.
Both changes are effective for tax years beginning on or after January 1, 2018. This means Oregon’s laws before amendment, which define sales as all gross receipts not allocated, should apply to any 2017 IRC Section 965 adjustments.
An Oregon regulation specifically includes dividends in the definition of gross receipts while identifying 10 items that are generally excluded from gross receipts, such as tax refunds and pension reversions. Oregon statutes also provide that the apportionment-factor denominator be reduced by any Oregon dividends-received deduction.
As discussed above, for years beginning before January 1, 2018, Oregon uses the location of the income-producing activity to assign receipts to the Oregon numerator. Taxpayers that can identify an income-producing activity associated with the dividend may be able to document a position to include the dividend in the Oregon denominator. Taxpayers subject to Oregon’s tax-haven rules may need to perform additional analysis.
Potential Next Steps
Even when available, factor relief may not be sufficient to achieve multistate apportioned income that fairly reflects the income from state business activity—whether or not it’s determined using market sourcing or income-producing activity principles.
Including dividend receipts in the factor may not alleviate distortion because dividend receipts are generally equal to net income from dividends, while receipts from performing services or selling property are generally the gross receipts derived from these activities.
Taxpayers with significant repatriation income or actual dividends that choose to include Subpart F income in their apportionable income may want to consider requesting alternative apportionment.
A modification of the Detroit formula could be a component of the requested relief. Because this formula generally includes only an affiliate’s current-year factors, taxpayers could request an inclusion of factors from every year associated with the earnings and profits that generated the repatriation or dividend income.
Taxpayers in this situation must determine each state’s procedure for requesting alternative apportionment. They can also seek formal or informal rulings. It’s important to note the requirements and time constraints for requesting rulings vary significantly from state to state, which means taxpayers can benefit from beginning this process as soon as possible.
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For more information about how tax reform may affect your CFC reporting requirements for state tax purposes, contact your Moss Adams professional or email firstname.lastname@example.org. You can also visit our dedicated tax reform page to learn more.