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On February 9, 2018, Idaho enacted House Bill 355 generally updating its conformity to the Internal Revenue Code (IRC) in effect on December 21, 2017 for tax years beginning on or after January 1, 20171
. Notably, H.B. 355 also selectively adopts provisions relating to the IRC sections which were enacted as part of federal tax reform, including an addition to income under IRC Sec. 965 (related to the one-time repatriation tax), as well as a required addback of any deductions permitted under IRC Sec. 965 and other special deductions.
On March 12, 2018, Idaho enacted a second IRC conformity bill, House Bill 463, which adopts the IRC in effect as of January 1, 2018 for tax years beginning on or after that date, and selectively requires additional modifications related to federal tax reform to compute state taxable income.2
Federal Tax Reform and State Conformity to the IRC
The adoption of H.R. 1, commonly referred to as the Tax Cuts and Jobs Act (TCJA), on December 22, 2017, provided a significant overhaul of the federal income tax system. The TCJA not only created entirely new sections of the IRC, but also made substantial changes to existing law. In addition, while most changes resulting from the TCJA are prospective in nature, certain aspects of the TCJA, including IRC Sec. 965, became applicable for the 2017 tax year.
The key to evaluating how the federal provisions in the TCJA will impact state income taxes lies in evaluating a state’s overall conformity to the IRC. Traditionally, state conformity to the IRC is achieved in one of three ways: (i) rolling conformity (i.e., automatically conforming to the IRC that is currently in effect); (ii) fixed date conformity (“static conformity,” i.e., conforming to the IRC as of a fixed date, which may or may not be the most recent version of the IRC); and (iii) selective conformity (i.e., conforming to only specific IRC sections).
As a general matter, rolling conformity states will automatically incorporate tax base changes contained in the TCJA and must pass legislation in order to decouple from any of those provisions. By contrast, in static conformity states, legislation must be passed in order to adopt any of the new provisions or modifications contained in the TCJA.
Included in the TCJA as part of a move to a federal territorial system of international taxation, IRC Sec. 965 implements a “transition tax,” imposing a one-time tax on previously unrepatriated foreign earnings. Mechanically, there are two steps in the transition tax calculation under IRC Sec. 965. First, under IRC Sec. 965(a), Subpart F income is increased by unrepatriated earnings from foreign subsidiaries (i.e., a gross income inclusion).3
Second, under IRC Sec. 965(c), there is a “participation exemption,” which provides a deduction that effectively reduces the tax rate on unrepatriated earnings to 15.5 percent on cash and cash equivalents, and 8 percent on non-cash assets.4
For static conformity states that adopt a version of the IRC prior to the adoption of the TCJA, IRC Sec. 965 and the other provisions contained in the TCJA will not be applicable to state taxable income absent legislative action. Furthermore, even in rolling conformity states that adopt the IRC currently in effect, many states exclude or allow a deduction from the state tax base for Subpart F income. In excluding or deducting Subpart F income, states may refer to specific provisions of the IRC contained within Subpart F, or may apply a more general exclusion of income arising under Subpart F, or income characterized as arising from a foreign source. Depending on the state’s specific language and the type of state conformity, questions may arise as to whether this deemed repatriation income (codified in IRC Sec. 965) falls within the state’s exclusion or deduction.
Further, the IRS released much-anticipated guidance March 13, 2018 on the reporting and tax payments for Section 965 inclusions on 2017 income tax returns.5
Accordingly, C corporation taxpayers are required to report both amounts for federal income tax purposes on new Form 965, Transition Tax Statement, rather than including them on Form 1120 in the computation of adjusted gross income. This reporting requirement could impact the inclusion or exclusion of this amount in the state taxable income computation.
Idaho House Bill 355
Historically, Idaho has conformed to the IRC on an annual static basis, adopting the IRC as of a fixed date. However, in H.B. 355, the state departed from its traditional static conformity basis and selectively conformed to certain sections of the IRC. Specifically, for tax years beginning after 2016, the state advanced the IRC conformity date from January 1, 2017 to December 21, 2017, which is one day prior to the effective date of the TCJA.6
However, H.B. 355 specifically provides that, for purposes of IRC Sec. 965 (related to repatriation of foreign earnings) and IRC Sec. 213 (related to personal income tax deduction for medical expenses), the state conforms to the IRC in effect as of December 31, 2017.7
In addition, to compute Idaho taxable income, H.B. 355 requires that a corporation add back any amount deducted under IRC Sec. 965(c) and “other special deductions.”8
By conforming to the IRC in effect as of December 31, 2017, and requiring corporations to add back the deduction permitted under IRC Sec. 965(c), H.B. 355 is effectively including the unrepatriated foreign earnings in the Idaho tax base without providing the deduction afforded under IRC Sec. 965(c) necessary to achieve the preferential rate. As a result, H.B. 355 could significantly increase a corporation’s Idaho tax base to the extent the amount is included in taxable income and if a deduction for Subpart F dividends is not available. Notably, Idaho does permit water’s edge filers to exclude 85 percent of dividends received from “payors incorporated outside the United States,” which could mitigate the impact of the IRC Sec. 965(a) income inclusion.9
Idaho House Bill 463
H.B. 463 returns the state to a static conformity basis for tax years beginning on or after January 1, 2018, by adopting the IRC in effect as of January 1, 2018.10
H.B. 463 incorporates the provisions of H.B. 355, including the requirement to add back any federal deductions taken under IRC Sec. 965 to compute Idaho taxable income. Also, H.B. 463 expands this disallowance provision and specifically requires corporations to add back amounts deducted under IRC Sec. 245A (related to the 100 percent deduction for qualified foreign dividends received), and IRC Sec. 250 (related to the 37.5 percent deduction for foreign-derived intangible income (FDII) and 50 percent deduction for global intangible low-taxed income(GILTI)).11
Also, the legislation changes the net operating loss computation by requiring an addition of any amount limited by IRC Sec. 461 (general rule limiting amount of deduction or credit to proper tax year under applicable accounting method).12
Notably, by updating IRC conformity, H.B. 463 allows for the inclusion of the pass-through deduction included in IRC Sec. 199A in computing taxable income.13
Further, H.B. 463 provides for a decrease of 0.475 percent to both the corporate and individual income tax rates and creates a nonrefundable state child tax credit.14
Both H.B. 355 and H.B. 463 highlight the ability of states to selectively conform to provisions of the TCJA and use federal tax reform as a means of raising new revenue. While H.B. 355 focused on two notable differences, H.B. 463 further expands the gap between the federal and state tax base for both corporations and individuals, while also allowing for reductions to applicable income tax rates.
The selective treatment of IRC Sec. 965 in H.B. 355 has drawn heavy criticism, as it appears to capitalize on the revenue-raising opportunity created by federal tax reform. Notably, this legislation was enacted prior to the release of relevant IRS guidance, which could impact its result. By returning Idaho to a static conformity basis for tax years beginning after 2017, H.B. 463 certainly highlights the legislative intent to include federal repatriation income in the tax base. Although critics of H.B. 355 have stated that they intended to file a trailer bill to provide the deduction permitted under IRC Sec. 965(c), it is important to note that the income inclusion could be largely offset by the current foreign dividends received deduction available under Idaho law for dividends received from foreign corporations. Further instruction from state tax authorities clarifying the extent to which the IRC Sec. 965(a) inclusion amount qualifies for the deduction would be helpful, especially in light of the recently released federal guidance.
Finally, it is notable that Idaho joins a select group of states allowing taxpayers to include the enacted IRC Sec. 199A pass–through deduction in computing taxable income. Combined with the decrease in income tax rates, this inclusion will almost certainly allow some taxpayers to reap the benefit of a lower state income tax bill as a result of federal tax reform.
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