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U.S. State Tax Considerations for International Tax Reform

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U.S. State Tax Considerations for International Tax Reform U.S. State Tax Considerations For International Tax Reform © Tax Analysts 2014. All rights reserved. Users are permitted to reproduce small portions of this work for purposes of criticism, comment, news reporting, teaching, scholarship, and research only. Any permitted use of these materials shall contain this copyright notice. We provide our publications for informational purposes, and not as legal advice. Although we believe that our information is accurate, each user must exercise professional judgment, or involve a professional to provide such judgment, when using these materials and assumes the responsibility and risk of use. As an objective, nonpartisan publisher of tax information, analysis, and commentary, we use both our own and outside authors, and the views of such writers do not necessarily reflect our opinion on various topics. Foreign Tax Credit Rules For Allocating State Taxes by Peter A. Lowy Peter A. Lowy is a member of Caplin & Drysdale. The importance of the intersection between state and interna- tional tax — and the occasional complexity at that intersection — is demonstrated by the rules for allocating and apportioning state income taxes for purposes of computing the U.S. foreign tax credit and its limitations. That crossroad also may be particularly precarious. Without the necessary mix of technical state and international tax skills, the rules regarding the allocation of state taxes may present traps for the unwary. For many corporate tax departments, tackling this subject requires collaboration between the state and federal tax teams in order to properly evaluate how to maximize FTCs and mitigate the risk that the IRS will claim that credits are subject to a greater limitation based on a different allocation of state taxes. I. The FTC Limitation Rules In general, taxpayers may elect to take an FTC under section 901 in lieu of a deduction for foreign taxes paid. Section 904 limits the amount of the credit that may be taken under section 901 to, basically, the U.S. taxes paid multiplied by a fraction of foreign income to worldwide income. Accordingly, the more income that is foreign, the greater the percentage of foreign taxes that is eligible for the FTC. That is important for taxpayers in excess credit positions. In computing foreign-source income under section 904, some expenses must be allocated or apportioned between domestic and foreign income. Sections 861(b) and 862(b) set forth the general standard for apportioning expenses. The implementation of that basic framework is contained in an intricate and arcane set of Treasury regulations located in section 1.861-8. As discussed below, state income taxes are one expense that must be allocated and apportioned under that regulatory regime. 146 TAX ANALYSTS A. Application to State Income Taxes Corporate tax professionals not versed in the intricacies of the U.S.-source rules may ask why state income taxes are even an issue. After all, there is a long series of U.S. Supreme Court cases suggesting that states may not tax ‘‘foreign’’ income. For ex- ample, in Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159 (1983), in deciding whether California may include in its pre-apportioned tax base the income of subsidiaries operating outside the United States, the Supreme Court confirmed the basic principle that states ‘‘may not tax value earned outside its borders.’’1 And even though state apportionment formulas may include foreign income in their pre-apportioned state tax base, courts recognize that the results of formulary apportionment only tax income reasonably allocable to the state — hence, not foreign income.2 So by definition, because states can’t tax foreign income, aren’t state income taxes definitely related (and thus allocable) to domestic income? Not so — at least not according to the U.S. Treasury and IRS. Before the Tax Reform Act of 1986, it may have been industry practice to source all state taxes to domestic income and thus not reduce foreign-source income for determining the allowable FTC. That practice found support in then-existing Treas. reg. section 1.861-8, which dated back to 1977,3 and Rev. Rul. 79-186, which clarified the treatment of state taxes under the 1977 Treasury regulations. However, following the 1986 tax act, that changed. Lower U.S. tax rates and increased attention to allocation of expenses put pressure on the FTC computation. The administration released Rev. Rul. 87-64,4 which revoked Rev. Rul. 79-186 and altered the treatment and allocation of state taxes for purposes of the FTC limitation rules. Focused on inbound companies, the 1987 rev- enue ruling set forth an apportionment method between effec- tively and noneffectively connected income. On the heels of the 1Container, 463 U.S. at 164. See also Complete Auto Transit Inc. v. Brady, 430 U.S. 274, 279 (1977); Barclays Bank PLC v. Franchise Tax Bd., 512 U.S. 298, 311 (1994). 2See Shell Oil Co. v. Iowa Dept. of Revenue, 488 U.S. 19, 30-31 (1988). 3See Treas. reg. section 1.861-8(e)(6) (1977). 41987-2 C.B. 166. TAX ANALYSTS 147 ruling, and consistent with it, Treasury and the IRS issued proposed regulations in December 1988 that set forth the alloca- tion of state taxes for purposes of the FTC. Treasury also proposed to apply the rules retroactively to 1977. That created an uproar, especially from oil companies, which were typically in excess credit positions and thus among the most harmed by the new state apportionment regime. Chevron Corp. and Mobil Oil Corp., for instance, commented that the proposed regulations were founded on a flawed and false premise — that any part of state taxes were levied on income earned in foreign countries. If that were true, then the state tax would be uncon- stitutional, they argued. They also said the regulations discrimi- nated against U.S. multinationals because foreign companies would receive greater benefit from U.S. state taxes than U.S. multinationals, at least those in excess credit positions. That would put U.S. multinational oil companies at a competitive disadvantage to foreign-owned. The oil companies were not alone in their protestations. Joining the chorus was a range of stakeholders, including the Multistate Tax Commission; the Council of State Chambers of Commerce; and several states, including California, Florida, and Idaho. The objections from the non-oil-company stakeholders mostly concurred with and supported what the oil companies said. Those groups also emphasized the negative economic impact the regulations would have on state economies and other constituents and raised technical challenges, many of which may have been trivial and diluted the more important messages. In light of the public comments, Treasury, the IRS, and industry engaged in constructive dialogue. With discussion came understanding. Yes, states are prevented from taxing foreign income, but there is income that is treated as foreign source under the code that is well within the authority of the states to tax.5 The easiest example is export income, which is treated as half U.S. source and half foreign source under the code. Other examples include foreign-source royalties or interest, dividends, 5See Mobil Oil Corp. v. Commissioner, 445 U.S. 425, 437-440 (1980) (suggesting a distinction between federal geographic source of income from state concepts of income derived from activities within the state). 148 TAX ANALYSTS and subpart F inclusion. At least, that was Treasury’s view, and it prevailed as the underlying premise to the section 1.861-8 regs. Not all taxpayers were convinced, however. The final regula- tions, issued in March 1991, and subject to a correcting amend- ment in May 1991,6 were challenged in the U.S. Tax Court.7 In 1995 the Tax Court upheld the validity of the final regs, a decision that was never appealed or called into question by later court decisions. B. Understanding the Regulations The regulations for allocating state income taxes for FTC limitation purposes are, in the words of the U.S. Tax Court, ‘‘exceedingly complex.’’8 Subsections (e) and (g) of Treas. reg. section 1.861-8 is where the rubber really meets the road in the arcane intersection of state and federal tax practice. To apply the federal regulations governing the computation of FTC limitations, an understanding of state tax systems in every jurisdiction in which the company operates is necessary. The regulations require everything from knowing whether a state includes foreign-source income, to which related companies’ income and factors are included in the state formula, to whether dividends treated under section 862(a)(2) as income from sources outside the United States are included. In certain instances, the regulations also invoke a separate accounting exercise, require consistency with the Uniform Division of Income for Tax Pur- poses Act, and require hypothetical amounts of state tax to be computed in states with no income tax. Those exercises present a challenge for many corporate tax departments, particularly because while most state tax profes- sionals have a good understanding of the federal tax rules — as federal tax is typically the starting point for state tax — the reverse is less often true. Federal tax practitioners, who are ordinarily responsible for the company’s FTC computation, often know little about state tax systems. Consequently, effectively 6See T.D. 8337. 7Chevron Corp. v. Commissioner, 104 T.C. 719 (1995). 8Id. at 727. TAX ANALYSTS 149 navigating the regulations often requires teamwork between a company’s federal and state tax compliance groups. Treasury reg. section 1.861-8(e)(6) contains the body of the rules. The general principle therein states that deductions for state income taxes ‘‘shall be considered definitely related and allocable to the gross income with respect to which such state income taxes are imposed.’’ Accordingly, if a state income tax is imposed partly on foreign-source income, then that part of the taxpayer’s deduction for state income taxes that is attributable to foreign-source income is definitely related to foreign-source income.
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