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Tax Executives Institute

Houston Texas

February 21, 2017

STATE FEDERAL CONFORMITY ISSUES

Jordan M. Goodman, Partner

Marilyn A. Wethekam, Partner

Horwood Marcus & Berk, Chicago IL

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Agenda

• Policy Considerations

• Definition of Taxable Income

• Basic Issues:

– Non-conformity – Tax Base

– Foreign Source Income

– Depreciation

– IRC Section 199

– Net Operating Losses

• Consolidated Return Regulations:

– Basis Issues

– Deferred Transaction

– Group Composition

– Loss Limitations

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Policy Considerations

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Why Non-Conformity?

• Revenue raising

• Administrability

• Economic stability

• Equality/horizontal equity

• Economic inequality/vertical equity

• Neutrality/free market

• Political order

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Definition of Taxable Income

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Definition of Taxable Income

• The moving (piggyback) federal tax base:

– Some states’ income tax laws define terms by reference to the IRC as it exists for the current taxable year;

• The static federal tax base:

– Some states’ income tax laws define terms by reference to the IRC as of a specific date; or

• Adopt only specific IRC provisions.

• Starting point is federal taxable income

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Basic Issues

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Non-Conformity –Tax Base

• Federally deferred income:

– IRC Sec. 311(b) provides that certain distributions of

appreciated property trigger income that is recognized by

the dividend payor,

– Exception: if the distribution is an intercompany

transaction, in which case the gain is deferred.

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Non-Conformity –Tax Base

• Domestic dividends

– IRC section 243 provides for a deduction for dividends received from domestic corporations

• 100% requires at least 80% common ownership

• 80% owns 20% or more of the stock

• 70% owns less than a 20% stock interest

• State taxation of REITs

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Non-Conformity –Tax Base

• State taxation of foreign-source income

– IRC § 61, “gross income means all income from whatever source

derived…”

• IRC sec. 245 provides for a DRD:

– From a 10% owed foreign corporation to the extent of the U.S.

source portion of the dividends;

– Equal to 100% of the dividends received – gross income from all

sources is U.S. and

– Equal to 100% of the dividends received from a foreign sales

corporation (FSC).

• State prohibited from discriminating against foreign commerce.

– Treatment of foreign dividends.

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Depreciation

• Federal law

– Code Section 167 allows for depreciation deductions

• Accelerated cost recovery system (ACRS)

– On August 13, 1981, President Reagan signed into law the Economic Recovery Tax Act (“ERTA”) of 1981, which provided for ACRS. ACRS was based on a recovery period, instead of useful life under the then-elective Class Life Asset Depreciation Range System (ADR).

• Modified Accelerated cost recovery system (MACRS)

– With the Tax Reform At of 1986, Congress modified ACRS; MACRS allows for a somewhat lesser accelerated rate of recovery than ACRS.

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Bonus Depreciation

• On March 9, 2002, President Bush signed the Job Creation and Worker Assistance Act of 2002. – Immediate federal tax deduction of up to 30 percent.

– Acquired on or after September 11, 2001.

– The law applied to tax years ending after September 10, 2001.

• Jobs and Growth Tax Relief Reconciliation Act of 2003– Increased federal bonus depreciation amount to 50% (from 30%)

– Applied to property which is acquired by the taxpayer after May 5, 2003, and before January 1, 2005.

• On February 13, 2008, Economic Stimulus Act of 2008– That law provided for a 50% bonus depreciation for property acquired

during the 2008 calendar year.

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Bonus Depreciation

• On February 17, 2009, President Obama

signed into law H.R. 1, the American Recovery

and Reinvestment Act of 2009 (P.L. 111-5).

• The law extends through 2009 the bonus

depreciation provision included in the 2008

stimulus package.

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Depreciation Compliance

• Maintaining state depreciation schedules, in addition

to:

– Federal tax depreciation schedules;

– AMT depreciation schedules; and

– Financial accounting depreciation schedules

• Disposition of assets:– Gain/loss amounts will vary from federal gain/loss

amounts because of different tax basis at the federal/state

level.

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IRC § 179

• Section 179 provides for an election to expense certain depreciable business assets.

– 2007-2010:

• The expense amount was increased from $25,000 to $125,000.

– 2009 American Recovery & Reinvestment Act.

– 2010 Hiring Incentives to Restore Employment Act:

• Deduction increased to $250,000 for 2009 & 2010

– Phase-out: if cost of section 179 property placed in service during such taxable year exceeds $200,000 (or $500,000 in the case of taxable years beginning after 2006 and before 2011) (or $800,000 with 2009 law change).

• More than 10 states have decoupled from Section 179

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IRC § 199

• The American Jobs Creation Act of 2004.

– Section 199 provides for a deduction equal to:

• 3% - tax years beginning in 2005 & 2006

• 6% - tax years beginning in 2007, 2008, & 2009

• 9% - tax years beginning after 2009

– Of the lesser of:

• The qualified production activities income of the taxpayer for the taxable year, or

• Taxable income (determined without regard to Section 199) for the taxable year.

– About 20 states have indicated that they will not conform to Section 199.

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Net Operating Losses

• IRC Section 172: – NOLs arising in tax years beginning before August 6, 1997

• Carried back three years; or

• Forward 15 years.

– NOLs derived from tax years beginning after August 5, 1997• Carried back two years; or

• Carried forward 20 years.

– NOLs generated in tax years that end in 2001 and 2002• The carryback is five years.

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Net Operating Losses

• 2/17/2009: American Recovery and Reinvestment Act

– 5 year carryback for 2008 NOLs,

– But, applies to small businesses only

• 11/6/2009: Worker, Homeownership, and Business Assistance Act

– 5 year carryback for 2008 & 2009

– All businesses (except TARP)

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States’ Deviations from Federal NOL Rules

• The carry-back period may differ;

• Prohibited from carrying back the NOL;

• The carry-forward period may differ;

• Cap on NOL carry-back;

• Cap on NOL carry-forward;

• Cap on NOL deduction in a tax year.

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States’ Deviations from Federal NOL Rules

• Post-apportioned NOLs;

• Limitation on utilizing NOLs generated in a year whenthe taxpayer was not conducting business in the state;

• Existence of state NOL may depend on existence of aFederal NOL;

• Some states allow pre-apportioned NOLs to only offset Federal Taxable Income (the starting point); or

• Separate entity NOLs when filing consolidated or unitary/combined tax returns.

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Section 385 Debt Equity Regulations

• Major impact of regulations:

– Creates a general operating rule under which the Internal Revenue Service (“IRS”) (but

not taxpayers) may treat certain related-party debt instruments partially as debt and

partially as stock, based on the substance of those instruments under general federal tax

principles (Prop. Treas. Reg. § 1.385-1)

– Certain related-party debt instruments will automatically be re-characterized as stock

unless specific contemporaneous documentation and information requirements are met

(Prop. Treas. Reg. § 1.385-2)

– Certain related-party debt instruments will automatically be treated as stock if issued as

part of specific related-party transactions (“Tainted Transactions”) or if an entity

borrows from a related party 36 months before or after engaging in a Tainted Transaction

(Prop. Treas. Reg. §§ 1.385-3 and -4)

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Section 385 Debt-Equity Regulations

• Prop. Treas. Reg. § 1.385-1(e) specifically provides:

– “Treatment of consolidated groups. For purposes of the regulations under section 385, all members of

a consolidated group (as defined in §1.1502-1(h)) are treated as one corporation.”

– Known as the “consolidated group exception” or the “single entity rule”

• State income tax impact:

– Will the states conform to the proposed regulations and/or the consolidated group exception?

– Will the states have powers independent of the IRS to police these rules?

– Can states make debt-equity determinations that are different than those made by the IRS?

– What effect will the Section 385 Regulations have on the interest expense provisions of existing state

add-back statutes?

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Consolidated Return

Regulations Deviations

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Basis Issues

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• When states do not conform to the federal

consolidated return regulations taxpayers must

separately track state and federal basis in property

– Outside Basis (parent’s basis in subsidiary’s stock)

– Inside Basis (subsidiary’s basis in its assets)

Basis Issues

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• Outside Basis: Separate reporting states may not adjust a parent’s outside

basis in subsidiary stock

– Treas. Reg. § 1.1502-32: a parent receives basis adjustments to its basis

in a subsidiary’s stock for the subsidiary’s income or losses

• Reduces/eliminates multiple taxation within consolidated group

– Separate reporting states may not permit similar adjustments to parents’

basis in subsidiary stock

Basis Issues

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• Outside Basis Example: Parent and subsidiary file a federal consolidated return. Parent sells subsidiary’s stock.

• Federal: the parent’s gain is partially or entirely reduced per the federal consolidate return regulations basis adjustments.

• State: the parent may recognize gain or loss measured by its original basis (unadjusted by consolidated return regulations)

– See, e.g., Appeal of Rapid American Corp., 96-SBE-019A-0284 (Cal. Bd. Equal. May 8, 1997)

Basis Issues

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• Inside Basis: Separate reporting states will not change a

subsidiary’s basis in its assets (“inside basis”)

– Pursuant to IRC § 108, corporation does not recognize

cancellation-of-debt income (“CODI”), but instead reduces

tax attributes, including basis in property

– Pursuant to Treas. Reg. § 1.1502-28, parent “looks

through” subsidiary to the subsidiary’s assets, causing the

subsidiary to reduce inside basis.

• States decoupling from federal depreciation rules.

Basis Issues

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• Inside Basis Example: Parent and subsidiary are part of the same federal

consolidated group. Parent is insolvent, declares bankruptcy and debt is

cancelled.

– Pursuant to IRC § 108, parent does not recognize cancellation of debt-

income, but reduces tax attributes, including basis in property

• Pursuant to Treas. Reg. § 1.1502-28, parent “looks through”

subsidiary, causing subsidiary to reduce basis in its assets

– Separate reporting states generally will not reduce subsidiary attributes

based on parent non-recognition under IRC § 108

• But see MCI Comm. Servs. v. N.J. Dir., Div. of Taxation, N.J. Tax

Court Dkt. 013905-2010 (July 20, 2015)

Basis Issues

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Deferred Recognition Treatment

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• Separate Reporting States:

– Non-Conformity to the federal consolidated return

regulations

• Combined or Consolidated Reporting States:

– Full Conformity to consolidated return regulations

– Partial Conformity to consolidated return

regulations

– Non-Conformity to the consolidated return

regulations

Deferred Recognition

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• Separate Reporting States – Non-Conformity

– Entities under common ownership remain separate

taxpayers

– Other separate reporting provisions may apply to alter or

defer recognition

• e.g., IRC §§ 482, 267(b)

• Certain separate reporting states have discretionary authority

to combine or consolidate related taxpayers

– See: N.J. Stat. Ann. § 54:10A-10(c)

Deferred Recognition

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• Combined Reporting States – 3 types

– Full Conformity States (e.g., NY, CO)

• Defers recognition consistent with Treas. Reg. § 1.1502-13

– Partial Conformity States (e.g., CA)

• California mostly conforms to Treas. Reg. § 1.1502-13, but otherwise does not conform to FCRR (e.g., Treas. Reg. § 1.1502-32 basis adjustments); see Appeal of Rapid American Corp., supra

– Non-Conformity States (e.g. TX, UT)

• Require each entity to calculate income on separate company basis

• Eliminate gains or losses on intercompany transactions

– May not follow FCRR basis rules for determining basis of property in parties’ hands following transaction

Deferred Recognition

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• Interplay between basis and deferral regimes

• Federal excess loss accounts (“ELAs”)

– Parent’s reduction to basis in subsidiary stock can create

negative basis

– Parent does not realize gain until ELA is “triggered” by

selling or liquidating stock

• California Deferred Intercompany Stock Accounts (“DISAs”)

– California law deviates from ELA treatment

Deferred Recognition

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• Combined or Consolidated Reporting States

– Caveat: Taxpayers filing in states that have

combined or consolidated reporting may still have

group composition issues.e.g., Virginia (only

companies with separate company nexus included

in return)

Deferred Recognition

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Group Composition

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• Composition of a Group Return Can Significantly Alter the Tax Treatment and

Impact Tax Liability of the Group

• Types of Federal Returns:

– Separate Returns

– Consolidated Return

• Types of State Returns:

– Unitary Combined Return

– State Consolidated Return (same as or different than federal composition)

– State Hybrid Combined/Consolidated Return

– Selective Combined Return

– Separate Company Return

Group Composition

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• States that conform to the consolidated return

regulations still may not conform when both entities

are not in the same return.

• Full and partial conformity states may thus default to

separate company treatment.

Group Composition

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• Reasons for disconnect between federal and state groups

– Constitutional limitations

• The U.S. Constitution prohibits states from including certain

entities (i.e., non-unitary entities).

• No similar limitation for federal consolidated groups (consolidated

return regulations do not require unitary relationship).

– States may also include entities that do not meet federal consolidated

return ownership threshold

• Federal: 80% vote and value;

• States: 80% vote or value; 50%+ vote or value

Group Composition

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• Other factors determining composition:

• States that include entities in combined group based on

separate entity nexus determinations

– e.g., Virginia

• States that have combined/consolidated reporting that do

not require unitary relationship.

– Taxpayer may choose to file combined even if not

constitutionally permissible for state to require

combined reporting

– e.g., Colorado, New York (old law)

Group Composition

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Loss Limitations

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• Federal Consolidation and SRLY Rules

– A federal consolidated group computes its net

operating loss on a group basis.

– However, federal consolidation principles limit the

use of NOLs by the consolidated group when

generated by a member in a separate return year.

Loss Limitations

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• SRLY Requirements

– If a NOL in a separate return year arose in a year when the corporation

could have joined in a consolidated return, then the group can use the

loss.

– If the loss arose during a year in which the corporation was not a

member of the affiliated group, then:

• Use of NOLs generated by a member in a separate return year

limited to the extent of that member’s taxable income in the group

in the carryover year;

• Cannot use loss to offset income of other members.

Loss Limitations

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• State Conformity

– Some, but not all, states follow federal consolidation principles (e.g. § 1502)

• e.g. Alabama follows federal SRLY rules (Ala. Code §40-18-39)

– Computation performed at the unitary group or separate member level

• Illinois – NOL computation follows group theory

• California – NOL computation follows separate company theory

Loss Limitations

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• Coca-Cola Enterprises Inc. v. Ala. Dep’t of Revenue, No.

Corp. 09-641 (Ala. Dep’t of Rev. Feb.14, 2013)

– Alabama ALJ held that an affiliated group can deduct

NOLs from years when the group did not file an Alabama

consolidated return.

• Corporation that incurred the loss must have been a

member of the group at the time the loss arose.

• Group must meet definition of “affiliated group” at the

time the loss arose

• Thus, an affiliated group can exist before it elects to file

an Alabama consolidated return

Loss Limitations

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QUESTIONS

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Thank You

Jordan M. Goodman

Jgoodman@Saltlawyers.com

312-606-3225

Marilyn A. Wethekam

mwethekam@saltlawyers.com

312-606-3240

Horwood Marcus & Berk, Chartered

500 W. Madison St. , Suite 3700

Chicago Illinois 60661