While it is not expected that any federal tax reform would have significant implications for state taxes, such changes would almost certainly make state taxes a bigger priority for technology companies. As with the rest of the country, state policymakers are eagerly waiting to see what federal changes may be forthcoming in order to determine how and whether they must respond.
Passage may very well occur after state legislatures have adjourned, resulting in at least a period of conflicting state and federal tax laws. Whether state legislatures would convene emergency sessions to address any inconsistencies is almost impossible to predict.
1. Federal conformity
States generally use the Internal Revenue Code as the starting point for determining state-taxable income and, if it changes, the state tax base should change as well.
However, each state is different in how it conforms to Internal Revenue Code changes. Some states are so-called “fixed” conformity states, meaning that conformity to changes in the Internal Revenue Code is not automatic and requires legislative action to conform. Most other states are so-called “rolling” conformity states, meaning that conformity to changes in the Internal Revenue Code is automatic unless the state legislature expressly chooses to decouple from the federal changes.
There are also a few so-called “selective” conformity states, meaning that conformity to changes in the Internal Revenue Code depends on which provision of the Internal Revenue Code is changed and, in some cases, whether the state legislature has to update its conformity of that provision to that change.
While it is still too early to tell, it seems likely that doing nothing would result in increased state revenue for states that conform to the changes in the Internal Revenue Code simply because while these states conform to base changes, they generally do not conform to rate changes.
Thus, because all of the current proposals suggest expanding the federal tax base in order to effectively reduce tax rates, the base expansion should flow through to the states but not the rate reductions, resulting in increased state tax revenues.
2. State and local tax impact on the technology sector
The following is a discussion of how the Blueprint and the Trump plan may impact the technology sector from a state tax perspective.
a. Taxation of foreign earnings
Depending on the plan and on the type of earnings (future or accumulated), repatriated foreign earnings would likely be treated as a dividend. For state tax purposes, dividends are generally allowed a 100% deduction.
However, some states tax a portion of the dividend. In Massachusetts, for example, 5% of the apportioned share of a foreign dividend that is received from a non-unitary corporation would be subject to tax. In California, a corporation may eliminate 100% of dividends received from a unitary subsidiary included within the same worldwide combined report.
If it has a water’s-edge election, 75% of dividends received from a foreign subsidiary that is a member of the unitary group can be excluded, while 25% of the apportioned share remains subject to California tax.
Worse, if the dividend is supported by non-unitary earnings and profits (for example, the dividend is paid by an acquired foreign corporation that had substantial non-unitary earnings and profits), no dividend-received deduction is currently available in California.
b. Cost recovery
Technology companies in capital-intensive subsectors that move operations to the US should benefit from the proposed change to the cost recovery rules. However, this benefit may not exist at the state level, as many states have decoupled from federal expensing and favorable depreciation due to revenue losses.
If so, the federal benefits may result in an increased state tax compliance burden because, for example, companies would have to compute state-only depreciation.
c. Interest expense
Technology companies that usually borrow funds for such things as investment and stock buyback programs may be negatively impacted by the proposed change to the interest expense rules. However, the negative impact may not exist at the state level, as many states have decoupled from federal expensing and favorable depreciation due to revenue losses.
d. Other state tax considerations
Under both plans, it is expected that many credits would be eliminated but that the research tax credit would remain, which is a benefit for technology companies. This should not have much impact at the state level, as states usually impose state tax credits separately from those provided under the Internal Revenue Code.
However, the recent calls for federal tax reform have emboldened officials in at least one state to revisit certain tax credits. A state tax official from California recently announced that his priorities for the 2017 legislative session include scrutinizing tax expenditures and that expenditures related to research tax credits are likely candidates for increased scrutiny.
The federal tax reform is not expected to have any direct impact on sales or property tax, but that does not mean that there would be no indirect impact. Reductions in federal tax would mean that sales tax and property tax would likely result in a higher percentage of the overall tax burden.
Additionally, to the extent that a state’s income tax revenue is impacted by the reform, it is likely that there would be efforts to fill that shortfall through other tax means. This could take the form of rate increases, expansion of the tax base, parcel taxes, transfer taxes or even new taxes depending upon the revenue impact.
To counteract those effects, some states would take steps to attract the investment that could come from the repatriation of earnings. States may expand their credits and incentives programs in an effort to attract technology investment, and the critical jobs they provide, to their jurisdictions.
Technology companies with manufacturing operations or contract manufacturing arrangements outside the US may then move those operations back to the US, or at least require their contract manufacturers to do so.
Some technology companies have already begun discussions in anticipation of legislation, and this trend will likely swell as details of the reform emerge.
Discussions prior to investment generally will maximize a company’s ability to obtain more favorable credits and incentives and lower their above-the-line tax burden.