VIDEO: Corporate State Tax Outlook
As tax reform takes center stage both globally and within the U.S., what are the implications for state tax practitioners? Over the past year, there has been an increasing focus nationally and internationally on preventing "erosion" of the tax base that governments allege is the result of intercompany financial transactions involving interest and royalties, highly-publicized "inversions," and other tax planning techniques. These government initiatives do not take place in a vacuum, as state revenue departments are paying close attention as well.
In this three-part video alert series, Crowell & Moring Tax partner Don Griswold discusses various international and federal tax reform proposals that could have a major impact on companies' state tax posture and their planning for audit defense litigation around the country. These include the International Organisation for Economic Cooperation and Development's (OECD's) BEPS action plan relating to corporate tax base erosion and profit shifting, as well as the federal thin capitalization and earning stripping rules affecting interest deductions. Don also discusses the prospects for legislation that might allow another repatriation of some corporate earnings from overseas, what is on the horizon for corporate taxpayers, and how they can begin to prepare for potential changes.
Part 1: How to Handle Possible Federal Tax Repatriations
Part 2: Federal Thin Cap Earnings Stripping
Part 3: How to Handle Federal Thin Cap Earnings Stripping
What is the context for the International OECD BEPS Action Plan?
With corporate tax reform looming on the global and national horizons, tax executives and counsel need to be thinking in advance about the state tax implications and how to mitigate the expected and unexpected consequences. One of the biggest issues to face on the international front is the BEPS action plan.
What is the OECD BEPS Action Plan?
The OECD is going on the offensive here to shut down what they see as corporate tax base erosion and profit shifting. That's B-E-P-S or BEPS. Its key action steps are halting tax arbitrage, stopping foreign affiliate dumping, permitting artificial avoidance of tax jurisdiction, tightening up transfer pricing, and requiring disclosure of what they call "abusive tax transactions."
How might BEPS impact state tax audits?
"Watch out!" The rhetoric that the OECD is using in its BEPS action plan is like state tax challenges on steroids. They're talking about double non-taxation, stateless income, tax symmetry. The list goes on. What this is going to do, I predict, in the state tax world is give more of an impetus to the states to get even more aggressive and accelerate their efforts to go after corporate industry with unitary combined filing audits, nexus challenges, market sourcing. You know the list—this gives them more language to do it. What does this mean? We as an industry need to remember there is another side to the story, and we need to get that story out. Get it out at audit conferences, get it out in the courtroom in litigation, get it out in the public square.
What is the context of Federal Thin Cap Earnings Stripping?
One of the key Federal tax reform proposals out there is a tightening up of the thin capitalization and earning stripping rules affecting interest deductions, and this is really going to be a problem for state tax. Now, why? You are familiar with the current program that requires deferral of deductions for excess interest payments, but the proposals would make some of those permanent. Permanent disallowance of deductions.
Why would permanent disallowance matter for state tax?
Think about what's happening here. When a corporation pays interest to a foreign affiliate, it gets some of those deductions disallowed. When it pays the same kind of interest to a domestic affiliate, no disallowance. That makes it more expensive to borrow money from an overseas affiliate than domestically. Well that's flat out patent discrimination against foreign commerce. Now, while Congress is free to discriminate against foreign commerce if it wishes, it's another story when the states conform to that process in their laws, because states are bound by the dormant commerce clause, and this is flat out discrimination, invalidated—its crystal-clear invalidation by the U.S. Supreme Court. So that means if these modifications happen, taxpayers are going to have to litigate to defend their rights.
Is another repatriation on the way?
Remember back in 2005 when Congress essentially created a tax holiday to corporations to bring earnings back to the U.S.? Well the participation exemption and foreign income intangible tax provisions in these proposals do very much the same kind of thing. That means that, again, states are going to be looking at a revenue windfall, and they may need to tweak the dividends received deduction rules received to get that windfall. But, whether or not they do, this means that taxpayers are going to have to plan for how to escape that.
How can corporate taxpayers prepare?
The potential for audit disputes and litigation on this is very real. It will involve inconsistent DRD—dividends received deduction—rules, income characterization, business vs. non-business income, inclusion in the sales factor, and factor representation as well. Now, what this means for taxpayers is that they are going to begin to face the potential for real litigation which they can mitigate with structural planning. So a tax executive and counsel really right now should begin thinking about planning for the repatriation vehicle well in advance.
What is the outlook for corporate taxpayers in the near term?
Tax reform is uncertain. We don't know where it's going to go on the international and national stages. But what we do know is that thoughtful, advanced planning and preparation for litigation can really help a company mitigate the potential state tax impacts.
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