New Treasury Rules Could Affect Federal and State Tax Revenue

States may reap some revenue rewards following the rollout of new rules by the U.S. Treasury Department related to corporate income taxes.

On April 4, 2016, the U.S. Treasury Department announced the issuance of new regulations that are intended to make it more difficult for companies to pursue corporate inversions—the practice used by companies to reincorporate overseas in order to reduce their tax burden on income earned abroad—and to reduce subsequent profits for tax purposes through a tactic called earnings stripping. Earnings stripping is a technique employed by companies after a corporate inversion to minimize U.S. tax obligations by transferring debt to a foreign parent company and declaring the interest on the debt as a deduction.

The federal government levies the highest corporate tax rate in the developed world, at 35 percent, and also taxes income earned overseas. Most other countries employ a territorial method, meaning that only income earned in that country is taxed.

Corporate inversions and the practice of earnings stripping not only deprive the federal government of taxable income, but also reduce state government revenue as well. What’s more, when income is stripped out of the U.S. federal tax base, it is also being stripped out of the state tax base. How much depends on the structure and nuances of individual state tax provisions.

The rule is designed to curb corporate inversions by changing the way assets of companies are counted for triggering inversion thresholds for federal tax purposes. The current rules do not apply if the foreign company’s shareholders own more than 40 percent of the combined company. This has led some foreign companies to increase in size by acquiring multiple U.S. companies over a brief period of time.
The new rules would exclude the stock of the foreign company attributable to the assets acquired from an American company within three years prior to the date of the latest acquisition. The rule targets earnings-stripping by allowing the government the authority to block the deduction of interest a company pays on the debt lent from a U.S. company to its foreign parent company.

The average state corporate income tax rate is about 6 percent nationwide. Most states that tax corporate income take a portion of the federal corporate taxable income and apply that to the total in-state sales. Corporate inversion directly lowers the federal number that is applied to in-state sales, resulting in much lower revenues for states. The U.S. Public Interest Research Group estimates that states lose $20.7 billion to offshore tax havens annually.

President Barack Obama has repeatedly called upon Congress to enact legislation aimed at preventing these practices. In an April 5 statement at the White House, Obama told reporters, "When companies exploit loopholes like this, it makes it harder to invest in the things that are going to keep America’s economy going strong for future generations. It sticks the rest of us with the tab. And it makes hardworking Americans feel like the deck is stacked against them."

House Ways and Means Chairman Kevin Brady of Texas told Congressional Quarterly that the Treasury Department’s proposal will, “make it even harder for American companies to compete and will further discourage businesses from locating and investing in the United States. This approach continues to be a misguided, missed opportunity that will hurt American workers and their families.”

Senate Finance Committee Chairman Orrin Hatch of Utah urged the administration to work with Congress on broader tax reform, telling The Hill, “a comprehensive tax overhaul that reduces the rate, transitions to a territorial tax system with base erosion protections, and addresses earnings stripping will equip American businesses with the certainty they need to invest in a future here at home.”

While both parties in Congress agree that the corporate tax rate needs to be addressed and the tax code needs to be simplified in general, the chances of that happening during an election year are slim.  Many lawmakers have long objected to a piecemeal approach to reform, arguing the entire tax structure needs to be addressed.

Meanwhile, a recent report by the Rockefeller Institute depicts slowed revenue growth for states in 2016. The forecast of state personal income tax growth was 4.6 percent in fiscal year 2016 and 4.4 percent in fiscal 2017, down from 7.8 percent actual growth reported in 2015. Sales taxes are expected to rise by a median of 3.5 percent in 2016 and 3.9 percent in 2017, down from actual growth of 4.5 percent in 2015. Because of these revenue declines, state policymakers must continue to consider ways to fill budget gaps and address funding shortfalls.

The debate over federal tax reform is likely to continue for some time. In the meantime, the states continue to monitor economic development trends and adopt strategies to attract businesses and boost economic growth.