The following state tax developments were enacted during the third quarter of 2022 and should be considered in determining a company’s current and deferred tax provision pursuant to ASC 740, Income Taxes, for the quarter ended Sept. 30, 2022. This information summarizes the listed developments and may not provide additional nuanced considerations that may be relevant for provision purposes. For questions about these quarterly updates or other recent legislative and regulatory developments, please reach out to your tax adviser for more information.
State specific updates
Alabama clarifies subject to tax exception to intercompany addback
On Aug. 31, 2022, the Alabama tax tribunal issued a taxpayer-favorable verdict that provides clarity on how the intercompany interest addback and associated subject-to-tax exception provisions should apply. The taxpayer in the case filed Alabama returns claiming a deduction for intercompany interest expense paid to an Ireland affiliate. The interest income was included in the affiliate’s Ireland return but was fully offset by a deduction for interest expense paid to an affiliate in Luxembourg. Although the taxpayer’s Ireland affiliate was seemingly serving as a conduit or pass-through for intercompany interest expense in the back-to-back transactions described by the facts, the tax tribunal held that the transaction between the taxpayer and the Ireland affiliate as well as the affiliate’s treatment of the transaction for tax purposes satisfied the specific requirements of the subject-to-tax exception in the state’s intercompany addback rules. Taxpayers currently adding back intercompany expenses for Alabama purposes under similar fact patterns should carefully review the decision to determine if those addbacks are appropriate. For additional information, please read our alert: “Alabama tax tribunal rules taxpayer entitled to interest deduction.”
Arkansas lowers corporate income tax rate
On Aug. 11, 2022, Arkansas enacted Senate Bill 1, lowering the highest marginal corporate tax rate from 5.9% to 5.3% for tax years beginning on or after Jan. 1, 2023.
Idaho lowers corporate income tax rate
On Sept. 1, 2022, Idaho enacted House Bill 1, reducing the corporate tax rate from 6.0% to 5.8%, effective Jan. 3, 2023.
Illinois updates sales throwback rule
Amendments published in the Illinois Register on Sept. 9, 2022, update the state’s sales throw-back and throw-out rule. Previous versions of the rule provided that a taxpayer selling into a foreign country would be subject to throw-back/throw-out to the extent an income tax treaty exempted the taxpayer’s activities from taxation in the destination jurisdiction. Under the amended rules, to the extent a taxpayer’s activities in the foreign jurisdiction create taxable presence but are exempted from income taxation under treaty, the taxpayer will be considered to be subject to tax in the foreign jurisdiction, and no throw-back or throw-out will be required. The amendments are effective for tax years ending on or after Dec. 31, 2022. For more information, please read our alert: “Illinois adopts changes to throwback/throw-out rules for foreign sales.”
Iowa releases guidance on reduced corporate income tax rate
On Sept. 27, 2022, the Iowa Department of Revenue issued Order 2022-03, which updates the corporate income tax rate applicable to tax years beginning after Jan. 1, 2023. The Order provides that the top two corporate income tax brackets should be reduced to 8.4% from 9.8% and 9.0% for 2023 and beyond. The rate change is related to legislation enacted in March of 2022 (House File 2317), which provides for annual rate decreases over several years, contingent on certain revenue goals.
New Jersey adopts combined reporting regulations
On Aug. 18, 2022, New Jersey adopted final regulations reflecting law changes originally enacted in 2018, including mandatory unitary combined reporting. The regulations provide guidance on various issues related to the computation of combined group income, tax and credits, many of which have been previously addressed through technical guidance released by the state. Among other significant updates, the regulations provide guidance on the treatment of treaty-protected income for foreign affiliates included in the combined reporting group, explain that unity is presumed in the first year for acquired or newly formed entities and provide guidance on the treatment of net operating losses of combined group members in the case of an acquisition or disposition. The regulations are effective Sept. 19, 2022.
New York City enacts bright line nexus threshold
On Aug. 31, 2022, New York enacted Senate Bill 9454/Assembly Bill 10506. Among other changes, the legislation includes provisions to establish a bright-line nexus threshold for New York City income tax purposes; any corporation with over $1 million dollars of receipts derived from New York City sources will be considered to have nexus with the city. The legislation further provides that combined group taxpayers should aggregate city sales for all group members with over $10,000 of city-sourced receipts or 10 city-based customers in order to determine whether the combined group meets the $1 million threshold. These provisions will be applicable to tax years beginning on or after Jan. 1, 2022.
Oregon case clarifies state interpretation of P.L. 86-272 protection
In an unpublished opinion (TC Case No. 5372) decided on Aug. 23, 2022, the Oregon Tax Court ruled that a cigarette manufacturer was not protected from Oregon income taxation under P.L. 86-272. The taxpayer had independent contractors within the state who were authorized to accept returns from retailers for any reason under the taxpayer’s product guarantee and who routinely placed “pre-book orders” of the taxpayer’s products for Oregon-based retailers. Although the pre-book orders were technically sent outside of the state of Oregon for approval and processing, the Tax Court determined that the pre-book order process involved activities outside of mere solicitation of sales. The Tax Court determined that, based on the specific facts in this case, the taxpayer’s in-state activity exceeded the protections of P.L. 86-272.
Pennsylvania enacts corporate rate reductions, economic nexus standard and market-based sourcing for intangibles
On July 8, 2022, Pennsylvania enacted House Bill 1342, making several notable corporate income tax changes. The commonwealth’s current corporate income tax rate of 9.99% will decrease by a full percentage point in 2023, followed by half-percentage point reductions each year after until the rate reaches 4.99% beginning Jan. 1, 2031. Additionally, the legislation codifies the economic nexus standard previously addressed in Corporate Tax Bulletin 2019-04, which states that entities having over $500,000 of receipts sourced to the commonwealth will have established nexus for corporate income tax purposes. The bill also provides for a change from cost-of-performance to market-based sourcing for revenues associated with several categories of intangible property, including patents, royalties, franchise agreements and sales or exchanges of securities. For additional information on these and other tax changes enacted by House Bill 1342, please read our alert: “Pennsylvania budget includes significant state tax changes.”
Tennessee releases updated guidance addressing GILTI, section 174
In the updated version of the Franchise and Excise Tax Manual released in August, Tennessee provides guidance on the income tax treatment of research and development (R&D) expenditures under section 174 to reflect law changes enacted by the state in March of 2022. Tennessee decouples from the federal rules for section 174 enacted by the Tax Cuts and Jobs Act which require R&D expenses to be capitalized and amortized for tax years beginning on or after Jan. 1, 2022; the guidance clarifies that these expenses will be deductible as incurred for state purposes. Additionally, the updated guidance clarifies that, although Tennessee taxes 5% of a taxpayer’s global intangible low-taxed income (GILTI), there should be no apportionment factor inclusion related to the portion of GILTI included in the state tax base.
West Virginia issues updated apportionment regulations
West Virginia released final regulations (Reg. section. 110-24-1 to 110-24-7) clarifying corporate income tax apportionment changes previously enacted in 2021, including a move to single-sales factor apportionment, market-based sourcing and elimination of the state’s throwback rule. The regulations provide hierarchical rules on how to determine the location of the taxpayer’s market for a specific transaction with specific guidance aimed at clarifying sales sourcing for in-person services, electronically delivered services, services sold to a related member and certain architectural, engineering and advertising services. The regulations also provide guidance on the application of the state’s market-based sourcing rule for sales of intangible property, enumerating specific sourcing rules for marketing intangibles, production intangibles, broadcasting intangibles, contract rights, software transactions and digital goods and services, among others.
Texas amends research and development credit rules
On July 29, 2022, amendments to the Texas research and development (R&D) credit (Texas Admin. Code section 3.599) were published in the Texas Register, generally effective Aug. 4, 2022. The amendments come in response to comments received from tax practitioners and other stakeholders on changes to the R&D credit rules previously published by the state in October 2021. The 2021 amendments contained several major Internal Revenue Code conformity issues as they provided that certain key federal R&D credit regulations were not within the definition of “Internal Revenue Code” for Texas purposes. The July 2022 amendments correct some of the conformity issues by adding Reg. section 1.742-2 and portions of Reg. section 1.41-4 to the Texas definition of the Code, which allows for certain prototype research activities (pilot models) to be eligible for the R&D credit for Texas purposes. Note that internally developed software continues to be ineligible for the Texas R&D credit; the July 2022 rule changes do not alter the previous amendments made in October 2021 related to internally developed software.
Additionally, under the previous rules, a change in membership of the combined group resulted in potential loss of the R&D credit carryforward. The July 2022 amendments remove the language related to credit carryforwards and provide guidance on how the R&D credit of a combined group should be attributed to each of the members. Under these revised provisions, R&D credit carryforwards are preserved as group membership changes.
The October 2021 and July 2022 amendments to the Texas R&D credit rules made other significant changes not specifically addressed here, and significant differences exist between federal and Texas R&D credit rules as a result of both sets amendments.
State pass-through entity tax workarounds
The TCJA limited the individual taxpayer deduction for state and local tax (SALT) payments to $10,000 a year ($5,000 for a married person filing a separate return). SALT payments (including income and real property taxes) that exceed these amounts are no longer deductible by individual taxpayers unless the payments are in pursuit of a trade or business.
As a response to the TCJA's limitation, several states began to adopt a pass-through entity-level tax intended as a workaround. In 2022, at least 30 jurisdictions will allow a workaround. In the third quarter of 2022 and as of the date of this article, New York City advanced the effective date of its workaround from 2023 to 2022.
The complete list of jurisdictions that have adopted a pass-through entity-level tax as of the date of this article include the following (with the first effective year in parentheses): Alabama (2021), Arizona (2022), Arkansas (2022), California (2021), Colorado (2018), Connecticut (2018 and mandatory), Georgia (2022), Idaho (2021), Illinois (2021), Kansas (2022), Louisiana (2019), Maryland (2020), Massachusetts (2021), Michigan (2021), Minnesota (2021), Mississippi (2022), Missouri (2023) New Jersey (2020), New Mexico (2022), New York (2021), New York City (2022), North Carolina (2022), Ohio (2022), Oklahoma (2019), Oregon (2022), Rhode Island (2019), South Carolina (2021), Utah (2022), Virginia (2021) and Wisconsin (2018).
These pass-through entity tax workarounds have complex accounting implications. Depending on the characteristic of a particular pass-through entity, the accounting treatment may be that the tax is treated as a payment on behalf of the partner (an equity transaction), or as an entity level expense. Please consult with your tax advisor to understand any ASC 740 or other accounting implications associated with these tax regimes.
State tax implications of the Inflation Reduction Act
On Aug. 16, 2022, President Biden signed the Inflation Reduction Act (IRA), enacting numerous changes with corporate income tax consequences, most notably the creation of a new corporate alternative minimum tax (CAMT), a 1% excise tax on repurchases of corporate stock and an increase in IRS funding for enforcement activity. While most states do adopt, in part or in whole, the provisions of the Code which govern the computation of federal taxable income, states generally do not adopt the Code provisions related to excise taxes and would not be affected by the new stock repurchase excise tax. A few jurisdictions do, however, impose a state-level alternative minimum tax that references the same Code sections that govern the new CAMT regime. The majority of these jurisdictions and state-level minimum tax regimes conform to the Code in effect before the passage of IRA, so legislative action would be required to conform to the new CAMT rules. As with any significant federal tax legislation, taxpayers should be aware that many states will likely use upcoming legislative sessions to respond to the recent changes in federal tax law. While the initial state level impacts of the IRA appear to be minimal, taxpayers should work closely with their tax advisers to monitor state legislative activity to incorporate or address recent federal changes. An RSM alert discussing the provisions of the IRA, as passed by the Senate and eventually enacted unchanged, is available for more information.