Rhode Island enacts sweeping corporate tax reform legislation
Enacts mandatory unitary combined reporting
TAX ALERT |
On June 19, 2014, Rhode Island Governor Lincoln D. Chafee signed into law 2014 H 7133 Substitute A as Amended (the Act), enacting sweeping changes to Rhode Island's corporate income and franchise tax structure. As a result, Rhode Island will join with many of its fellow states by implementing mandatory combined reporting for unitary businesses, single sales factor apportionment for C corporations, and market-based sourcing for sales of services. Additionally, Rhode Island will create an S corporation minimum tax, and will repeal its franchise tax. These sweeping changes will be effective for tax years beginning on or after Jan. 1, 2015, leaving taxpayers relatively little time to perform an impact analysis and implement appropriate internal responses.
In greater detail, the Act provides:
Mandatory combined reporting for unitary businesses
Joining 22 other states, for tax years beginning on or after Jan. 1, 2015, Rhode Island will require unitary businesses to report income tax on a combined basis. Specifically, the Act requires each C corporation which is part of a unitary business with one or more other corporations to file a return for the combined group. For purposes of the new regime, the term "unitary business" means the activities of a group of two or more corporations under greater than 50 percent common ownership that are "sufficiently interdependent, integrated or interrelated through their activities so as to provide mutual benefit and produce a significant sharing or exchange of value among them or a significant flow of value between the separate parts."
The Act specifically excludes a number of types of entities from the combined group. For example, insurance companies, state banks, mutual savings banks, federal savings banks, trust companies, national banking associations, building and loan associations, credit unions, and loan and investment companies do not fall within the definition of the term "corporation" for purposes of the new regime, and, thus, are not subject to the combined reporting rules. Further, non-US corporations that derive 80 percent or more of their sales from outside of the U.S. may not be included in a combined group regardless of whether they would otherwise qualify as includable corporations. Non-US corporations not otherwise excluded from the combined group are only included to the extent that the non-US corporations' income is subject to the provisions of a federal income tax treaty.
Note that the use of a combined report does not disregard the separate identities of the members of the combined group. Each taxpayer member is responsible for tax based on its taxable income or loss apportioned to Rhode Island.
Elective combined reporting for affiliated groups
The Act also permits an affiliated group of C corporations, as defined in section 1504 of the Internal Revenue Code, to elect to be treated as a combined group. This election may be made regardless of whether a unitary relationship exists. Once an election is made, it may not be revoked in less than five years unless approved by the tax administrator.
Tax haven provisions
The Act also contains "tax haven" provisions, which provide that certain attributes of non-US members of a combined group must be included in a combined return if the tax administrator determines that the non-US member is organized in a "tax haven" country. However, such attributes may be excluded from a report if the non-US member is organized in a tax haven country that has a federal income tax treaty with the United States and (1) the transactions conducted between non-US member and the other members of the combined group are done on an arm's length basis and not with the principal purpose of avoiding tax, or (2) the member establishes that the inclusion of such attributes in the combined group report is unreasonable.
For this purpose, the term "tax haven" means a jurisdiction that has no or nominal tax on income and either (1) does not engage in tax information sharing, (2) has a tax regime that lacks transparency, (3) facilitates the establishment of foreign-owned entities without the need for substantive local presence or prohibits such entities from having an impact on the local economy, (4) excludes residents from tax benefits allowed to non-residents, or (5) has otherwise established a tax regime which is favorable for tax avoidance. Rhode Island has not yet promulgated a base list of jurisdictions deemed to be tax havens within the meaning of this rule, leaving taxpayers with the complicated task of analyzing the tax regimes of each jurisdiction in which they do business.
Treatment of NOLs and tax credits
Pursuant to the Act, net operating losses (NOLs) generated in tax years prior to 2015 may only be used to offset the income of the corporation that generated them, and deductions for NOLs may only be taken for NOLs that were sustained during a tax year in which a corporation was subject to tax in Rhode Island. For NOLs created in tax years beginning on or after Jan. 1, 2015, the allowable loss is the same that would be permitted under section 172 of the Internal Revenue Code. Such NOLs may not be carried back and may be carried forward only up to five succeeding years. NOLs cannot be shared among members of a combined group, and must be calculated and traced separately.
Likewise, tax credits earned in tax years beginning before Jan. 1, 2015 may only be used to offset the tax liability of the corporation that earned them. Credits earned in tax years beginning on or after Jan. 1, 2015 may be applied to other members of the group.
Repeal of related party expense addback
With the adoption of mandatory combined reporting, Rhode Island repealed provisions requiring taxpayers to add back related-party interest and intangible expenses. This repeal potentially creates a disconnect, because the addition to income under prior law applied to transactions between members of an affiliated group as defined in section 1504 of the Internal Revenue Code, which may be different from a combined group of entities under Rhode Island law.
Adoption of single sales factor apportionment for C corporations
Pursuant to the Act, Rhode Island becomes the latest state to join the accelerating trend of adopting a single sales factor formula for corporate income tax apportionment purposes, moving away from the previous three-factor apportionment formula. It should be noted that the legislation specifies that C corporations are required to apportion their income using a single sales factor, and does not repeal prior law. Accordingly, it is arguable that all other entities must continue to apportion their income using an evenly weighted three factor formula. It is anticipated that Rhode Island will provide additional guidance regarding this issue.
Adoption of market-based sourcing for sales of services
The new legislation also requires C corporations to utilize market-based sourcing of service revenue in determining their sales factor for apportionment purposes. Specifically, the new law requires service revenue to be sourced to Rhode Island if "the recipient of the service receives all the benefit of the service in [Rhode Island]." If the recipient of the service receives only some of the benefit of the service in Rhode Island, then the revenue is included in the Rhode Island sales factor "in proportion to the extent the recipient receives benefit of the service in [Rhode Island]."
As with the adoption of single sales factor apportionment, the Act specifies that market-based sourcing applies to sales of services by C corporations, and does not repeal prior law related to the sourcing of sales of services. Accordingly, it is arguable that entities which are not organized as C corporations are not subject to the new market-based sourcing rules. Instead, such entities would arguably continue to source service receipts to Rhode Island only to the extent that the service was performed in Rhode Island. Again, additional guidance is expected.
Adoption of Finnigan rule
When determining apportionment for combined report purposes, Rhode Island has adopted the Finnigan test. Under this test, each member of a combined group must include their Rhode Island receipts in the computation of the sales factor, regardless of whether such member actually has nexus with the state for income tax purposes.
Corporate tax rate reduction
The corporate income tax rate has been reduced from the current rate of nine percent to seven percent for tax years beginning on or after Jan. 1, 2015.
S corporation minimum tax
For tax years beginning on or after Jan. 1, 2015, S corporations will be subject to a minimum tax of $500.
Franchise tax repeal
Pursuant to the Act, Rhode Island's franchise tax has been repealed for tax years beginning on or after Jan. 1, 2015. The franchise tax is currently a tax on authorized capital stock of $2.50 for each $10,000, with a minimum tax of $500.
Taxpayers must be very careful in determining the impact of the Act on their corporate income tax liabilities for tax years beginning on or after Jan. 1, 2015, as the changes involved deeply affect applicable filing methods, tax base computation, apportionment, and rates, and areas where additional guidance is needed could substantially alter cash taxes in certain situations. Additionally, taxpayers may have a short amount of time to consider the impact of these changes on reserves and deferred taxes for financial statement purposes. Lastly, taxpayers that have relied upon administrative pronouncements in taking a tax position should consider reviewing whether a particular pronouncement is rendered ineffective by the enactment of the Act.
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