California Franchise Tax Board issues guidance on federal tax reform

The California Franchise Tax Board’s (FTB) communication plan is to release information on or before the following dates, addressing the California impact of various portions of the Tax Cuts and Jobs Act (TCJA):

• March 2, 2018
• March 26, 2018
• April 20, 2018 – Final Summary of Federal Income Tax Changes Report

The Feb. 12, 2018 preliminary report provided guidance in the following three areas of the TCJA:

Temporary reduction in medical expense deduction floor and alternative minimum tax

• Federal (prior law): Individuals may claim an itemized deduction for unreimbursed medical expenses, but only for expenses that exceed 10 percent of AGI. For tax years beginning before Jan. 1, 2017, the 10 percent threshold is reduced to 7.5 percent for taxpayers age 65 before the end of the taxable year.
• Federal (new law): For tax years beginning after Dec. 31, 2016, and ending before Jan. 1, 2019, the threshold for deducting medical expenses is 7.5 percent of AGI for all taxpayers. For tax years after Jan. 1, 2018, the threshold returns to 10 percent of AGI for all taxpayers. (see IRC section 56 and section 213)
• California guidance: California generally conforms to the itemized deduction for unreimbursed medical expenses under IRC section 213, as of the “specific date” of Jan. 1, 2015 with modifications. California allows a deduction for these expenses that exceed 7.5 percent of AGI. For the 2018 tax year, the threshold percentage is the same for both federal and the state. For tax years beginning on or after Jan. 1, 2019, the threshold will remain 7.5 percent of federal AGI for California income taxes.

Additionally, California does not conform to the federal change to the AMT threshold from 10 percent to 7.5 percent of AGI. For California AMT purposes, the threshold remains at 10 percent of federal AGI. (see California Rev. and Tax Code section 17062, 17062.3, 17062.5, 17201, 17241).

Limitation on deduction for state and local taxes

• Federal (prior law): Individuals were permitted a deduction for state and local real and foreign property taxes, state and local personal property taxes and state, local and foreign income, war profits, and excess profits taxes. A taxpayer may elect an itemized deduction for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes. Property taxes were allowed as a deduction if incurred as part of a trade or business, otherwise they are an itemized deduction. State and local income taxes are also an itemized deduction notwithstanding that the tax may be imposed on trade or business profits. No itemized deduction for property, income, or sales tax is allowed in determining a taxpayers AMT income.
• Federal (new law): For tax years beginning after Dec. 31, 2017, and beginning before Jan. 1, 2026, an individual may claim an itemized deduction of up to $10,000 for the aggregate of state and local property taxes not accrued in carrying on a trade or business, or an activity described in IRC section 212, and state and local income, foreign, income, war profits, and excess profits taxes (or sales taxes in lieu of income taxes) paid or accrued in the taxable year. Individuals are also not allowed a deduction for foreign real property taxes. Additionally, any amount paid in a taxable year beginning before Jan. 1, 2018, with respect to a state or local income tax imposed for a taxable year beginning after Dec. 31, 2017, the payment shall be treated as paid on the last day of the taxable year for which such tax is so imposed. An individual may not claim an itemized deduction for the 2017 tax year on a prepayment of income tax for a future taxable year in order to avoid the limitation applicable for taxable years beginning after 2017. The provision is effective for taxable years beginning after Dec. 31, 2016. (see IRC section 164)
• California guidance: California personal income tax law conforms relating to the deductibility of taxes under IRC section 164, as of the Jan. 1, 2015 specified date, with modifications. However, California does not allow a deduction for state and local, foreign, income, war profits, and excess profits taxes or the election to deduct sales taxes. (see California Rev. and Tax Code section 17201 and 17220)

Repatriation tax on untaxed earnings of foreign corporations

• Federal (prior law): U.S. corporations pay federal taxes on all income, regardless of source, and may claim a credit for taxes paid on its foreign-source income. For a foreign corporation, the foreign corporation’s U.S.-source income is subject to federal tax. Under the general rules, no U.S. tax would be paid on earnings of a foreign corporation owned by U.S. taxpayers until those earnings were actually distributed as dividends, or until the disposition of the stock of the foreign corporation. This system permitted a U.S. taxpayer to defer indefinitely U.S. taxation of profits earned by the foreign corporation by retaining the earnings in the foreign corporation and not distributing those earnings. Anti-deferral provisions were enacted by Congress in 1962 under subpart F of the IRC, and U.S. shareholders with a 10 percent or greater interest in a controlled foreign corporation (CFC) must include a pro-rata share of certain CFC undistributed foreign source income as a constructive dividend (subpart F income).
• Federal (new law): New IRC section 245A permits tax-free repatriations of future foreign profits of foreign corporation to 10 percent U.S. shareholders that are domestic corporations. Amended IRC section 965 imposes an immediate, one-time tax, at a reduced rate on U.S. shareholders on accumulated earnings of CFCs, or which have 10 percent U.S. shareholders, through a one-time deemed repatriation of those earnings. New IRC section 951A imposes a current tax (similar to subpart F) on a U.S. shareholder’s “global intangible low-taxed income” (GILTI) of a CFC. Certain aspects of the subpart F anti-deferral rules were modified, and several new provisions were enacted to prevent erosion of the U.S. tax base.
• California guidance: California corporation tax law conformity is through a specified conformity date, currently the IRC as of Jan. 1, 2015. One exception to this conformity are the water’s-edge election provisions. When a water’s-edge provision refers to an IRC provision, it is the IRC provision in effect for federal purposes for the same taxable period. Existing California law does not incorporate by reference IRC section 245A, 951A and 965. In addition, the water’s-edge provisions do not specifically refer to these same IRC sections. Therefore, existing California water’s-edge provisions do not conform to these repatriation provisions. Although California does not conform to IRC section 965, U.S. taxpayers with large cash reserves abroad may have an extraordinary repatriation dividend. Differences between federal and California tax law mean the repatriation amounts may be characterized as taxable distributions for federal tax but not for California tax, and vice versa. The FTB provides the following steps to calculate the repatriated amounts to be included in California taxable income:
  • Dividends are included in the apportionable income base
  • Dividends paid from earnings produced in years that the taxpayer filed on a worldwide basis are eliminated because those earnings were included in the worldwide combined report in the year that they were generated
  • The remaining dividends receive a 75 percent dividends received deduction (under the water’s-edge rules)
  • The remaining income is then multiplied by the taxpayer’s California apportionment factor
  • The taxpayer’s post-apportionment income is offset by any available net operating losses
  • The tax rate is applied
  • The resulting tax may be reduced by any tax credits that the taxpayer has available

Takeaways

California taxpayers should review the new guidance and reach out to their tax advisers with questions. State guidance and legislative responses to federal tax reform is evolving as states dissect the impact of many new provisions. State legislatures will be addressing federal reform responses throughout the next few months, with California intending to release several more reports on the changes. For more information on federal and state tax reform, please see RSM’s Tax Reform Resource Center.