Recent months have proved challenging, if not exhausting, for professionals in the state and local tax compliance arena, for several reasons that have been well chronicled over the past year. International tax provisions affecting the calculation of federal taxable income have created new types of confusion among taxpayers and tax preparers alike. Global intangible low-taxed income (GILTI) and foreign-derived intangible income (FDII) have now been incorporated into state tax jargon to the same degree as in international tax jargon. When taxpayers ask if they are affected by these provisions, advisors have become accustomed to using the stock answer, “it depends.”

While many concerns related to these new types of income have begun to be addressed, new ones continue to crop up, although often many of them are actually old ones resurfacing. GILTI and FDII are considered “previously taxed income,” which is born of “deemed” income that exists as “intangible” in one year and then “paid” in a later year; this process of reincarnating itself creates some interesting results. This article will provide an overview of this area and detail the issues CPAs need to be aware of when assisting affected taxpayers.

When Is Income Not Income?

The new provisions affect taxpayers investing in controlled foreign corporations. While not itself new, Internal Revenue Code (IRC) section 986(c), which governs how distributions of previously taxed foreign earnings and profits should be treated, has taken on a more impactful role in determining state taxable income for large multinational taxpayers. In the past, foreign exchange (FX) gains and losses, as reported on federal tax returns, were likely ignored on most state income tax returns due to the relatively low impact on federal taxable income. With this new class of income, however, an interesting question has arisen: What happens when IRC section 965 and deemed, or intangible, income are included in federal taxable income in one year, and a true-up of that income is included in federal taxable income in the next? Pursuant to section 986(c), this true-up could materialize as a significantly larger FX gain or loss connected with previously taxed income than in past years, and may relate to income that was not, in fact, “previously taxed” for state purposes.

Federally, there can be either an FX gain or loss depending on the average exchange rate of the taxable year for which the distribution is related. This is important because very few, if any, of the states have specifically addressed how to treat this gain or loss. Assume that a taxpayer files a tax return in State A reporting its federal starting point GILTI income in year one. State A does not tax GILTI income, so that income is excluded from state taxable income as a state subtraction modification. In year two, the same taxpayer trues up the previously federally taxed GILTI income and can now record an FX loss. Because this loss is in the taxpayer’s federal taxable income, which becomes the state taxable income starting point (as defined by state A’s statutes), the taxpayer is now receiving the benefit of a loss related to previously taxed income that it was never actually taxed on for state purposes. Can the state deny this loss?

When Is a Loss Not a Loss?

Most states take the position that the starting point for calculating state taxable income is federal taxable income, either before or after special deductions. The definition of federal taxable income relies upon the IRC in existence as of a certain date. States then create modifications that either add to or subtract from federal taxable income, resulting in a taxpayer’s state taxable income.

These modifications are defined by codifying state statutes and regulations or by relying on existing general statutes and providing official state guidance for specific items. Absent a codified state modification or official state guidance, is a taxpayer required to make a modification to federal taxable income simply because the result seems to unfairly benefit the taxpayer? Would such a taxpayer be allowed to exclude the FX gain if the situation were reversed?

The rule of thumb is that no modification to state taxable income is required or allowed unless specifically identified as a modification by state statute. Certain states, however, do not define federal taxable income in this manner. Instead, they choose to recreate the federal tax return using their own definitions of revenue and deductions without relying upon federal governances; California is one of these states. Other states (e.g., New York) opt to pick and choose which statutes of the IRC they will follow. In these states, a deeper dive must be performed to determine if this loss is allowed for state purposes.

In addition, what happens when the state includes over-arching language in its statutes that define net income in terms that exonerate the state from being required to accept the federal determination of taxable income? Often, a state will include generic language in its statute defining state taxable income which proclaims that the determination of the Commissioner of Internal Revenue as to federal taxable income is followed generally, but is not binding on the state’s commissioner of revenue. This leaves a back door for the state to redefine what it interprets as federal taxable income—a troubling thought indeed.

Each Case Is Different

Clearly, many states have discretionary language provisions that may allow state administrators to make the types of adjustments and modifications discussed above. Whether they will exercise such discretion will be a state-by-state determination based on each taxpayer’s specific facts and circumstances in the event of audit scrutiny. CPAs must be cognizant of these rules and the risks associated with them to properly advise their clients on these state tax compliance matters.

Corey Rosenthal, JD is a principal at CohnReznick LLP, New York, N.Y.
Coral Bernier is a senior manager of state and local tax services at CohnReznick’s Hartford, Conn. office.