Amendments to Temp. Regs - allocation of state income taxes against foreign source income. (Temporary Regulations) (International Taxation)by Kraisky, Benjamin P.
In December 1988, proposed Temporary Income Tax Regulations were issued by the IRS as a supplement to existing Temp. Regs. under Secs. 861(b), 862(b), and 863(a). As promulgated, these regulations provide general principles and specific examples of the allocation and apportionment of the deduction for state income taxes in the computation of taxable income from sources inside and outside the U.S.
As written, the underlying principle of the Regs. is that foreign source income is taxed when taxable income for state purposes exceeds U.S. source income for federal income tax purposes. However, these Temp. Regs. fail to take into consideration several factors upon which various states base their calculation of taxable income. The Regs. also make incorrect assumptions which tend to distort the manner in which most states tax income. Therefore, these Regs. will generate different results regarding the allocation and apportionment of state and local income taxes depending upon the specific states in which the corporation's required to file. Further, depending upon the number of state filings, a corporation would find itself performing numerous required calculations. Thus, compliance with these regulations will add significant costs and increase the administrative burden on U.S. multinationals.
States Do Not Tax Foreign Source
The general principle of the Regs. is flawed in its presumption that states tax foreign source income. They presume that arm's-length separate accounting is the proper method for determining U.S. and foreign source income, and that formula apportionment used by the states is improper and results in the taxation of foreign source income. The courts have addressed this issue and have determined that formula apportionment is merely a different method to arrive at the same result. The fact that states use a different method for sourcing income does not support the presumption that foreign source income is, in fact, taxed.
The U.S. Supreme Court in Container Corporation of America v. Franchise Tax Board, 463 US 159 (1983), reaffirmed the standing principle that under both the due process and the commerce clauses of the Constitution, a state may not "tax value earned outside its borders." In addition, the Court stated that "both geographical accounting and formula apportionment are imperfect proxies for an ideal which is not only difficult to achieve in practice, but also difficult to describe in theory." The Court further stated in Container: "but we have seen no evidence demonstrating that the margin of error (systematic or not) inherent in the three-factor formula is greater than the margin of error (systematic or not) inherent in the sort of separate accounting urged upon us by appellant." Thus, the Court has recognized formula apportionment as a viable alternative to separate accounting in arriving at the same intended result. Therefore, the presumption that this method automatically results in the taxation of foreign source income is incorrect.
Further, the regulations result in an inherent distortion by comparing the results of each method to the other in the various examples. Such comparisons cannot be made where the resulting difference is automatically presumed to relate to foreign source income. Differences will always result when any two methods of accounting are compared. The U.S. Supreme Court has recognized this fact; the regulations should likewise take this into account.
Regulations Fail to Consider State
Modifications to Federal Taxable
The basic principle of the Regs. assumes that foreign source income is taxed when taxable income for state purposes exceeds U.S. source income for federal tax purposes. This presumption fails to take into account the numerous state tax modifications to federal taxable income (other than state taxes) that routinely result in higher state taxable incomes. Following are four specific areas wherein federal and state differences occur in the determination of base income.
* Depreciation Deductions. Most states do not allow ACRS and MACRS depreciation deductions in arriving at taxable income. This modification alone significantly increases state income bases which will greatly distort the intended result of the proposed Regs.
* State and Municipal Interest Income. Generally all states require the inclusion in taxable income of interest income received on obligations of all state and municipal governments, with the frequent exception of the taxing state's obligations. Therefore, the regulations will attribute state taxes on such income to foreign sources.
* Net Operating Loss Deductions. Most states that permit such deductions (several do not) have adopted different rules than those for federal tax purposes under Sec. 172. Many states do not provide for the carryback of such losses to prior periods, but rather, limit such deductions to future years only. Further, such carryforward deductions are frequently limited to federal taxable income before state adjustments. Thus, corporations that have such deductions will generally have higher state than federal domestic source taxable income, with the result under these regulations that the state taxes will be attributed to foreign sources. Even when the deduction is the same as for federal purposes, a proper matching of the tax years would still be required to avoid distortion.
* Interest Expense. Several states require corporations to add back to federal taxable income all or some portion of interest expense paid or accrued to related parties. These states require such modification to avoid debt versus equity determinations. Other states require the attribution of interest expense (disallowance) to state exempt income (i.e., dividends from subsidiaries), or to non-business income (i.e., rents or royalties) which is directly allocated to the state where it was earned. The net effect of such modifications again causes state taxable income to be greater than federal.
These are a few of the state modifications to federal taxable income that result in higher state tax bases. Others include depletion and amortization expenses, bad debt deductions, and even salary and wage expenses to the extent they relate to stockholders or officers of the corporations.
As stated, the Regs. fail in their presumption that where state taxable income is higher than federal domestic source income, foreign source income is therefore taxed. Due to the various state modifications required, state taxable income will generally be greater than federal, regardless of any foreign source income. Therefore, the Regs. will result in significant distortion by sourcing state taxes attributable to such modifications to foreign sources.
Adverse Impact on U.S.
The proposed Regs. will have a significant adverse impact on U.S. multinationals due to the increased cost and administrative burden of complying with the required calculations. The cost of state and local tax compliance has increased dramatically over the last few years. Corporations are now forced to create entire tax departments and information support units just to comply with the various state filing requirements. These regulations in effect require additional preparation for each filing jurisdiction. They also require the calculation of hypothetical taxes for jurisdictions where the taxpayer currently does not file. Compliance with these Regs. will clearly add substantial costs to U.S. multinationals and will put them in an even greater disadvantage when competing overseas.
Further, the calculations required by the Regs. will create an enormous administrative burden, and will be extremely difficult to complete on a timely taxable income is based on federal taxable income, therefore, state tax returns cannot be completed until after the federal tax return has been finished. Nearly all of the states recognize this fact by having a filing due date after the federal due date or by providing extensions beyond the federal six-month period.
Compliance will require that state returns be completed prior to the filing of the federal tax return. As can be seen from the above, this will be virtually impossible for those taxpayers that require the entire extension period to complete their federal tax returns.
For the reasons discussed above, the Regs. as drafted, should be withdrawn pending further study. They incorrectly presume that states tax foreign source income. State taxes should be directly allocated to U.S. source income only. If the Regs. cannot be withdrawn, the distortions that they create should be corrected. In the meantime, taxpayers preparing returns requiring an allocation of state taxes to determine foreign source income should be aware that these Regs. may yield unanticipated results. The Regs. do provide for alternative calculations which should be considered and may provide some relief to adversely affected taxpayers.
Jeffrey B. Gotlinger Benjamin P. Kraisky
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
©2009 The New York State Society of CPAs. Legal Notices
Visit the new cpajournal.com.