How Sweeping Federal Tax Reform May Create Benefits (and Headaches) for Minnesota Businesses

Minnesota has just finished hosting the biggest, most exciting sporting event in the world. Not only did Super Bowl LII have an economic impact, it likely changed some perceptions that existed about the state.  Now an even more important event concerning the state’s future will be taking place in St. Paul this spring.  And the outcome of this event, much more than the Super Bowl, will impact both Minnesota's economy and perceptions about our state’s business climate.

On December 22, 2017, the President signed H.R. 1, commonly known as the “Tax Cuts and Jobs Act of 2017” (“Act”), into law, creating significant changes to federal tax provisions affecting C corporations, pass-through entities (“PTEs”), and individuals.  Minnesota does not conform yet to the changes in the Act.²  Absent federal tax reform, Minnesota’s 2018 tax legislation likely would have been minor or nonexistent.  But with federal tax reform now in place, legislators and the Governor have a unique opportunity to decide how to position Minnesota’s tax system for the next generation.

In our short-circuited pursuit of a homefield Super Bowl, Minnesota experienced a “miracle” with the Vikings’ exciting come-from-ahead-then-from-behind playoff victory.  Can we come up with another “miracle” by reforming the state’s tax system to take into account the new environment that businesses, employees, and shareholders will face as a result of federal tax reform?  Let’s examine how federal tax reform will ultimately affect Minnesota’s C-corporations, and what the Legislature might do in response, with the goal of a more cohesive, comprehensive, fair, and less-complicated corporate income tax system.  Because the corporate provisions should be viewed in their entirety, due to the interplay among the modifications, we have included considerations after each change to indicate which issues state legislators should keep in mind.

Corporate Tax Rates

Under the Act, the federal corporate income tax rate will be reduced permanently to 21% for tax years beginning after December 31, 2017.³ Minnesota’s current tax rate is nearly half of the new federal corporate income tax rate.  At 9.8%,⁴ Minnesota has one of the highest state corporate income tax rates in the United States,⁵ bested only by Iowa (12%)⁶ and Pennsylvania (9.99%).⁷

As Minnesota’s corporate rate is one of the highest in the nation, Minnesota taxes could have a more significant impact on the decision to do business or expand in the state as state taxes become a larger portion of a business’s effective tax rate due to a smaller federal deduction for state taxes paid.  As evidenced by the recent news of hundreds of companies (including several based in Minnesota) announcing expansions in the U.S., giving bonuses and raises to its hourly and salaried employees, and bringing dollars back from overseas--business leaders do take taxes into account when making decisions.

While Minnesota’s statutory rate is high, the amount of revenue the corporate income tax generates is relatively small compared to sales tax and individual income tax collections.  According to the November 2017 budget forecast by Minnesota Management and Budget, corporate income taxes will bring in only 5.5% of the state’s revenues over the next biennium.⁸  In comparison, the sales and use tax will bring in over four times as much revenue.  Individual income taxes will bring in nearly 10 times as much revenue.  Yet how Minnesota will conform to the federal corporate income tax changes will no doubt consume a great deal of the Legislature’s time this spring, just as it consumes the resources of corporate tax departments, lawyers, accountants, lobbyists, Minnesota Department of Revenue (“Department”) auditors, etc. to prepare, audit and defend returns filed – all resources that could be better deployed elsewhere.

One need not go as far as the 2009 Governor’s Commission on Tax Reform’s recommendation to abolish the corporate income tax, but given that a central theme in the recent federal tax reform was a dramatic reduction in the federal tax rate for corporations, a significant complementary reduction in the Minnesota corporate tax rate by the Legislature could serve to improve the attractiveness of the state’s business environment without hampering the overall budget.  For example, the Department estimates decreasing Minnesota’s corporate tax rate by 2% would reduce revenue by approximately $212 million per year, a small amount relative to the overall budget, but which could be offset by revenue increases from other changes.⁹  This change would drop Minnesota’s rate to 18^th highest in the country, well below California’s 8.84% tax rate and comparable to neighboring Wisconsin’s 7.9% rate.  At the same time, the imposition of a graduated corporate tax rate, similar to the individual rate, could be considered as a means to give smaller C corporations a break at their lower income levels.  The level of the corporate tax rate is an important issue and will be discussed throughout this article as the rate interacts with the various federal changes the Legislature must address.

Issue to Consider:  Seriously contemplate lowering corporate tax rates, in line with the recent reduction in the federal corporate tax rate, as a means to make Minnesota’s corporate tax system more competitive with other states.

Net Operating Loss Limitations

Net operating losses (“NOLs”) allow a taxpayer to offset its federal taxable income using losses generated from future or previous tax years in order to smooth out the taxes paid.  One of the provisions in the Act limits the use of NOLs to 80% of the taxpayer’s taxable income, without regard to the deduction.¹⁰  Previously, a taxpayer was only allowed to offset 90% of its income if it was subject to the corporate AMT.  The new provisions also eliminate the federal carryback provisions, but do allow the NOLs to be carried forward indefinitely.  While NOLs may be used up over time, they will never be able to completely offset taxable income in a particular year.¹¹

Like many states, Minnesota’s method of tracking and utilizing NOLs differs from federal law.  Minnesota has not followed the federal treatment of generating NOLs on a consolidated group basis, but rather tracks NOLs on a separate company basis within the unitary combined group, allowing a 15-year carryforward period.¹²  However, Minnesota does reference the federal NOL treatment of IRC § 172.¹³  Assuming Minnesota adjusts its conformity date of the IRC to December 22, 2017 or later, there is the open question of whether that change automatically translates into Minnesota adopting the limitation changes that occurred in IRC § 172.  If the state only conforms to the updated IRC, however, it appears the carryforward would remain at 15 years, which would be an unfortunate oversight.  Care must be taken when updating Minnesota’s NOL provisions that all consequences are considered.

The purpose of the NOL attribute (whether for federal or state) is to allow businesses to smooth out their income tax liabilities by allowing the use of losses generated in down years to offset income in profitable years without any arbitrary limitation.  For example, after experiencing several years of big losses, perhaps due to a recession, limiting the NOL deduction would put businesses at a disadvantage by requiring them to pay tax on a larger portion of their income in the very first year they are profitable.  Such an outcome could occur at the same time when businesses are coming out of a slump and want to reinvest in their equipment or workforce.

Two Issues to Consider:  Whether to decouple from the treatment in the Act and determine that the state NOL should not be limited, to ensure that the purpose of the NOL attribute is retained. In the alternative, whether to limit the state NOL in line with the Act’s unlimited carryforward, such a limitation should only be enacted in combination with other reforms considered in this article.

Dividends Received Deduction Equalized and Expanded

Prior to federal tax reform, the federal dividends received deduction (“DRD”) was 80% for dividends from 20% or more owned corporations and 70% for dividends from less than 20% owned corporations.¹⁴  These federal deductions have been lowered to 65% and 50% for domestic dividends, respectively.¹⁵  Due to the fact that the corporate tax rate has decreased from 35% to 21%, the effective tax rate on dividends received remains relatively the same.

Minnesota currently follows DRD treatment as in effect prior to federal tax reform.¹⁶  If Minnesota were to adopt the updated DRD percentages under federal tax reform (65%/50%), then the state should simultaneously reduce the corporate tax rate to match.  Since DRD and NOLs are both used as subtractions to compute taxable income (but the DRD cannot be carried forward), the Legislature should clarify that taxpayers can choose to use a DRD first to reduce taxable income in order to preserve NOLs to be used in future years.  It should be noted that the Department’s preliminary fiscal estimates for the impact of the Act do not reference the DRD percentage changes, presumably because Minnesota has a law specifying its own DRD percentage and because the reduced federal percentages were indeed linked to the lower federal tax rate.¹⁷

In addition, the federal regime now allows a 100% DRD of foreign earnings that are brought back to the U.S. beginning in 2018.¹⁸  Assuming Minnesota remains a water’s-edge state that would exempt foreign income from state taxation, the potential taxation of 20% of the foreign earnings returned to the U.S. as a dividend seems inconsistent.

Issues to Consider: Seriously contemplate matching any corporate tax rate decrease with a DRD reduction.  Additionally, Minnesota taxpayers may be better served if the Legislature waits for federal guidance on these international changes rather than beginning to tax foreign income for state purposes that is no longer being taxed federally.

Alternative Minimum Tax Repealed

The Act repealed the federal corporate Alternative Minimum Tax (“AMT”), a regime historically designed to require corporations to pay a minimum amount of tax on its income.¹⁹ Although the federal AMT ceases to exist, taxpayers may continue to use AMT credit carryovers, and may provide for certain AMT credits to be refundable.²⁰

Minnesota is one of just seven states that applies an AMT on corporations.²¹  Minnesota’s AMT requires corporations that meet certain requirements²² to compute its tax under AMT using a broader tax base while applying a lower tax rate.²³  To the extent this AMT exceeds the tax calculated using the standard method, the corporation must pay the additional amount.

Minnesota’s AMT calculation would not necessarily be impacted by the repeal of the federal AMT.  Currently corporations must determine their state AMT filing requirement, regardless of whether they are subject to the federal AMT.²⁴  However, various adjustments, such as tax-exempt interest income, depletion, adjusted current earnings, and certain dividends, used in calculating federal AMT are also utilized in calculating Minnesota AMT.²⁵

With the federal repeal of AMT and the various federal modifications located throughout the IRC, the Minnesota AMT calculation will likely be more complicated, confusing and burdensome (Is that even possible?) to taxpayers, if it remains.  Practitioners are currently required to prepare additional forms calculating AMT, AMT credits, and AMT NOLs, which also requires additional time and resources for the Department to audit.

Issues to Consider:  Seriously consider repealing the corporate AMT with allowance of a carryover of credits or refunds to taxpayers in order to reduce complexity, and particularly if NOL usage is limited.

Full Business Expensing & Limit on Interest Expense Deductibility

The Act provides an increase in business expensing, typically called bonus depreciation, and Sec. 179 expensing, allowing corporations to depreciate 100% of the cost of used or new property placed into service after September 27, 2017.²⁶

With respect to bonus depreciation, Minnesota has not conformed to the federal treatment, and requires corporate taxpayers to add back 80% of the bonus depreciation, but then allows the deduction over a five-year period.²⁷  Fully conforming to these provisions for both pass-through entities and corporations would reduce state revenues by approximately $560 million during the FY18-19 biennium.²⁸  For many businesses, the disparate treatment at the state level simply creates a timing difference for the deduction and may not be material.  For other businesses, the time value of money of being able to deduct the full cost of property placed in service in the first year versus over six years is a very real concern.

The Act also disallows any deduction of business interest expense in excess of 30% of adjusted taxable income with certain exceptions.²⁹  The restriction on interest expense is intended to be a complementary provision to the adoption of full expensing.  Congress wanted to encourage companies to invest in their operations but also to limit their ability to deduct both the cost of the property and interest expense on debt borrowed to purchase the property.  Since these provisions are linked, if Minnesota chooses to continue to decouple from bonus depreciation, then the prudent thing would be to decouple from the interest expense limitation as well.  Because Minnesota requires a balanced budget, lawmakers often partially conform to federal changes in order to bring in the requisite tax revenue or decrease tax expenditures.  However, in this case, a hybrid approach of requiring a lower addback percentage for bonus depreciation but allowing a higher interest expense limit for Minnesota purposes would add complexity to the tax system.

Conforming to the federal limitation on interest expense deduction would also be difficult because of the uncertainties involved when the federal consolidated group and the Minnesota combined unitary group composition differ.  At the federal level, the taxpayer is the entire consolidated group.  If a member of the federal group were to have substantial interest expense or substantial interest income, but not be included in the Minnesota return, this would raise an additional calculation and complexity to determine what, if any, interest expense limit would be shown on the Minnesota return.

Two issues to consider:  The provisions of full expensing and interest expense limitation should be viewed in tandem.  Consider whether Minnesota’s policy of decoupling from bonus depreciation should be continued, in which case the restrictions on interest expense deductibility should not be adopted either.  Alternatively, consider whether to adopt full bonus depreciation expensing, in which case the limitations on interest expense deductibility could be considered, along with guidance on how such limitations would apply to a Minnesota combined unitary group.

International Provisions

Corporations that have foreign income and/or operations will likely see significant changes to their taxes as part of federal tax reform.  To make things more difficult for businesses, states will likely differ on their treatment of the federal provisions creating a complicated, new subset of corporate tax.

Tax on Deemed Repatriation of Foreign Earnings (“Transition Tax”)

One of the biggest impacts for businesses with foreign income will be from taxation of deemed repatriation of foreign earnings and profit (“E&P”) as the U.S. moves to a quasi-territorial system of taxation.  If a U.S. shareholder owns at least 10% of a foreign corporation, the U.S. taxpayer is now required to recognize its share of accumulated deferred foreign E&P as Subpart F income to be taxed.³⁰  This deemed repatriation takes effect for the 2017 tax year.  However, the corporation can elect to pay the federal tax due as a result of the deemed repatriation over an eight-year period.

Should Minnesota choose to tax a portion of this foreign income, several issues arise.  If the foreign income is taxed, one could argue that apportionment relief should be given, in the form of foreign sales added to the sales factor denominator.  Another question is whether the foreign business that generated the repatriated income (potentially many years ago) is unitary, or integrated, with the domestic combined group filing in Minnesota.  If the foreign activity is not integrated, then the income may be excluded as non-business income.  For example, a construction company may hold Brazilian oil and gas investments that are managed separately and have no connection to their business activity in the U.S.  Minnesota would be prohibited from taxing the income the Brazilian entity earned over time if it was not integrated with domestic operations.  Non-business income issues are by nature fact-intensive exercises, convoluted for taxpayers to navigate and for the Department to audit.  Given the dollars at stake, however, it may be material for companies to analyze these legal and constitutional issues.

Under the Act, repatriated earnings that are cash and cash equivalents are subject to a lower federal deduction to reach an effective tax rate of 15.5%, while earnings attributable to non-cash investments receive a higher deduction in order to be taxed at 8%.  Minnesota’s law currently does not provide for bifurcation of these liquid and illiquid earnings resulting in one tax rate being applied to both.  Taxing liquid earnings (cash) and illiquid earnings (property, plant and equipment) at different rates would allow taxpayers to better plan cash flow in order to bring the earnings back to the U.S. in order to make the tax payments.

Another issue is timing.  Companies will begin filing their 2017 tax returns this spring (and at the very least, pay the remainder of their 2017 estimated income taxes), likely before the Legislature has a chance to decide on a course of action.  Even if companies extend their filings, this is an issue that cannot wait until next year.  Even if the income is taxable, Minnesota still has not adopted the 8-year federal election in which to pay the tax. Without a statutory clarification, taxpayers may be stuck paying the full tax bill on their 2017 return.

Issue to Consider:  Whether to adopt taxation of deemed repatriated foreign earnings at reduced rates and with nuanced changes keeping Minnesota’s budget, tax structure, business environment, and taxpayers in mind.

GILTI and FDII

The Act created a new Code section (951A), which imposes a tax on global intangible low-taxed income (“GILTI”) from a foreign subsidiary of a U.S. parent.³¹  The purpose of this provision is to require businesses to pay a certain amount of tax on foreign income that cannot be avoided by placing intangible assets in countries where the company does not have significant investments in tangible property.  A lower effective tax rate is achieved on GILTI income by allowing a 50% deduction after its calculation.  It should be noted that GILTI is income included in the gross income calculation for federal tax purposes, regardless of whether the income is distributed as a dividend from the foreign subsidiary to the U.S. parent.  However, there is tremendous uncertainty as to how GILTI would be treated by Minnesota (or any other state for that matter) for purposes of the corporate income tax base and sales factor.  Such treatment could vary according to whether the amount is deemed to be Subpart F income, classified as a dividend, or eligible for a deduction as foreign source income or as a DRD.

Based on Minnesota’s long-standing position that its taxation of corporations stops at the water’s-edge of the U.S., serious reservations must be addressed before Minnesota were to wade off-shore and begin taxing foreign activity.  Many of the same issues we addressed above are relevant here.  Is the foreign activity that generated GILTI unitary with the Minnesota combined group?³²  If not, there may be serious constitutional and legal concerns with Minnesota taxing that income.  Would sales of the foreign subsidiary be included in the Minnesota sales factor?  Since GILTI is netted among income and loss entities in the federal consolidated group and calculated as a single amount, how would a company unravel and modify its calculation if one or more entities were not included in the Minnesota combined group?  A larger federal deduction is allowed for GILTI, resulting in a lower effective rate than the standard 21% rate.  If Minnesota were to tax GILTI, would it follow suit and apply a larger deduction to this foreign income?

The Act also creates a deduction for Foreign-Derived Intangible Income (“FDII”) of domestic corporations.³³  (Don’t worry, if you are feeling guilty for not understanding GILTI, FDII is about fifty percent less complicated.)  FDII is income from the sale of property (including leasing and licensing) for foreign use or services provided to persons outside the U.S.  The Act carves out FDII income, which would currently be taxed on federal and state returns, and allows U.S. corporations to take an additional deduction after net FDII, which is the excess of FDII less income computed from a “routine return” based on 10% of tangible assets.  It is important to keep in mind that FDII is not foreign income, but domestic income derived from foreign sources and is already included in the tax base.

Similar to the current IC-DISC entity, which was retained as part of the Act, FDII focuses on export activities but covers broader incentives for U.S. corporations to retain intangible property domestically and to sell goods and services overseas.  Currently Minnesota does not conform to the Sec. 199 Domestic Production Activities Deduction (DPAD) that was repealed under the Act or the IC-DISC provisions, but requires an addback of deductions from both provisions.  Since the FDII deduction is not limited to a particular state, one may ask why Minnesota would want to encourage and incentivize a business from producing a good or service in California and selling it overseas.  Because GILTI and FDII could be viewed as interconnected, maintaining consistent tax policy may result in Minnesota decoupling from both of these provisions, similar to how the state treated DPAD and IC-DISC’s.

Another concern with Minnesota adopting GILTI and FDII provisions is that they are only available for C corporations at the federal level but not S corporations. If Minnesota were to tax this income and provide incentives, the Legislature must then decide whether S corporations should be treated differently and potentially put at a competitive disadvantage.

Adopting many of these complicated international business provisions would push Minnesota into a new realm of taxation.³⁴  Minnesota, like nearly 40 other states, has historically taxed companies on their domestic, water’s-edge activity, understanding that difficulties abound when states begin taxing companies’ foreign operations.  There are several practical reasons few states choose to tax worldwide income.  Before pushing to adopt a worldwide taxation regime, the Minnesota Department of Revenue should pause to ask whether its auditors are equipped to understand the foreign provisions, learn about each company’s foreign operations, and then appropriately audit the companies’ foreign books.  This is a tall task and one that would likely require the Department to hire additional audit, appeals and technical resources that could take away from other pressing endeavors.

Issue to consider: Given the current lack of federal guidance, Minnesota should seriously consider decoupling from the GILTI and FDII regimes in order to preserve Minnesota’s water’s-edge tax system and to minimize compliance and audit burdens, until it is known how the federal treatment will impact Minnesota.

Conclusion

As the Minnesota Legislature, the Department, and the Governor work as a team to create the sweeping state tax changes that are needed to address federal reform, the burdens and benefits it places on businesses should not be forgotten.  Several of the goals of federal tax reform were to increase investment in the U.S., encourage companies to purchase property, and return tax dollars to businesses to allow them to increase wages and their workforce, which businesses have pledged to do.  It would be unfortunate if Minnesota sees federal tax reform solely as an opportunity to impose increased state taxes on businesses by conforming to federal changes without lowering rates and considering the interplay of the modifications in totality.³⁵  Instead, the Legislature has the opportunity to reduce the corporate tax rate, repeal corporate AMT, take into account the interplay between full expensing and interest expense limits, and carefully evaluate the impact of adopting foreign provisions. To accomplish all of this, St. Paul may need a miracle of its own, but if they can do it, it will be remembered as more beneficial to Minnesotans than any last-second touchdown or Super Bowl party,