Some States May Accidentally Tax International Income Through Unintended NCTI Conformity
Even if state lawmakers passed legislation decoupling from international taxation under the TCJA’s tax on global intangible low-taxed income (GILTI), their state might be in line to incorporate the OBBBA’s replacement tax on net CFC-tested income (NTCI), which is far more aggressive than GILTI when imposed at the state level. More on that below.
SALT News and Updates
California’s Attorney General is expected to issue a title for a proposed one-time 5% wealth tax ballot measure very soon, which would allow proponents to begin circulating petitions to place it on the November 2026 ballot.
Worth Reading
My Tax Foundation colleagues Manish Bhatt and Abir Mandal have a new paper on P.L. 86-272, the 66-year-old federal law that limits state tax nexus for companies with only minimal contacts in a state. In recent years, some states have sought to erode the law’s protections by using, e.g., “cookie nexus” for physical presence. Manish and Abir argue against efforts to make the law a dead letter and make recommendations for strengthening and modernizing the law.
There’s a good article in Tax Notes State on evolving deference standards post-Loper Bright, with a particular focus on California and Texas.
Some States May Accidentally Tax International Income Through Unintended NCTI Conformity
Lawmakers in many states voted to decouple from the tax on global intangible low-taxed income (GILTI)—but in some cases, those actions will do nothing to prevent their states from conforming automatically to its successor, the tax on Net CFC-Tested Income (NCTI). And if policymakers objected to taxing GILTI at the state level, they’ll really hate how NCTI functions in the states.
At the federal level, NCTI operates as a minimum tax, imposing compensatory U.S. tax on income that is only minimally taxed abroad. U.S. parent companies can claim tax credits for foreign taxes paid by their foreign subsidiaries (controlled foreign corporations, or CFCs). If the foreign subsidiaries are meaningfully taxed abroad, they don’t owe anything in U.S. federal tax. But states don’t offer foreign tax credits, so state-level NCTI taxation applies to an apportioned share of all income of foreign subsidiaries, regardless of where the income was generated or how much tax was paid on it abroad.
I have a Tax Foundation blog post highlighting how some states are at risk of accidentally taxing NCTI, but I want to use this venue to explain precisely how this happens.
Consider three different approaches to excluding the Tax Cuts and Jobs Act’s tax on global intangible low-taxed income (GILTI) under IRC § 951A from state tax codes.
Iowa: “Subtract, to the extent included, global intangible low-taxed income under section 951A of the Internal Revenue Code.” Iowa Code Ann. § 422.35(12).
North Carolina: “[Deduct] Any amount included in federal taxable income under section 78, 951, 951A, or 965 of the Code, net of related expenses.” N.C. Gen. Stat. § 105-130.5(b)(3b).
Louisiana: “… there shall be allowed for each taxable year a deduction equal to the amount of dividends that would otherwise be included in gross income.” La. Rev. Stat. Ann. § 47:287.738(F)(1).
Did you catch the differences?
Iowa—along with Kansas, New Hampshire, and Tennessee—statutorily decouples from a particular provision called GILTI, which no longer exists. The new tax on NCTI is its successor and was written to the same code section, but NCTI is not GILTI, and the deductions those four states have for GILTI should not be assumed to capture NCTI.
North Carolina, by contrast, is one of fourteen states that exclude GILTI by statutory reference to § 951A or to a broader segment of the Internal Revenue Code that includes § 951A. In these states, subtractions or deductions for GILTI will provide the same exclusion for NCTI, since it is drawn to the same statute.
Louisiana, meanwhile, is one of twelve states where GILTI was excluded from the tax base through a determination that it constituted dividend income or Subpart F income and was thus eligible for deductions related to dividend or Subpart F income.
The same logic that underlies tax administrators' treatment of GILTI as dividend or Subpart F income should also apply to NCTI, though that is not guaranteed. (Arizona is of particular note because the statute explicitly identifies “global intangible low-taxed income” as constituting dividend income. That reference will not apply to NCTI, though arguably their general rule should have applied to GILTI—and would therefore apply to NCTI—even without that explicit language.)
GILTI and NCTI are not, strictly speaking, Subpart F income, which is an income class for income from a CFC that U.S. investors must include on their own income tax returns. However, federal law stipulates that GILTI and NCTI income “shall be treated in the same manner as” Subpart F income, and the two states that exempt GILTI (and now, presumably, NTCI) as Subpart F income both pick up that federal requirement.
Similarly, GILTI and NCTI are not necessarily dividends under the definition in IRC § 316. Importantly, however, they comport with the definition of deemed dividends as developed in court decisions and administrative rules. All states agreed that GILTI should be treated as dividend income. In states that offer a dividends-received deduction, GILTI received the benefit of that deduction. That’s true even in states that tax GILTI: some states only deduct a given percentage of dividend income, which kept some GILTI in the tax base.
States that offered a deduction for GILTI by classifying it as dividend income should continue to do so under NCTI. Still, it wouldn’t hurt for policymakers to gain assurances on this point.
Finally, even states that already taxed GILTI and now tax NCTI might want to scrutinize the way they conform. The ideal policy is to decouple, but even where NCTI is intentionally taxed, anachronistic references to GILTI can complicate matters. In Oregon, for instance, both the addback of the § 250 deduction and the provision of a partial dividends received deduction make specific reference to GILTI.
Of course, if you’re not particularly familiar with GILTI or NCTI, all of this might be pretty opaque. Let me close by quoting at length from one of my prior Tax Foundation blog posts discussing the state implications of a transition from GILTI to NCTI:
GILTI and the States
Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, the US taxed the worldwide income of US corporations and their affiliates, including controlled foreign corporations (CFCs) based abroad, while allowing such companies to take credits against their US liability for foreign taxes paid. Under the TCJA’s territorial tax system, foreign income is not taxed by default, but Congress wanted to avoid profit-shifting activity in response. GILTI was intended as a minimum tax on certain foreign earnings, undermining the potential tax benefit of such profit shifting. The new NCTI regime arguably provides a better calibration at the federal level, but a far worse one for states incorporating the provision into their own tax codes.
Under GILTI, federal law sought to distinguish between routine and “supernormal” returns, with lawmakers postulating that a CFC’s returns above 10 percent of the value of its tangible assets very likely constituted income from intangibles (e.g., patents, trademarks, copyrights, and other forms of intellectual property from which royalties are derived). This initial 10 percent was excluded under the qualified business asset investment (QBAI) exclusion, which represented a rough-and-ready deemed return on physical capital. Any returns above 10 percent were subject to GILTI.
The remaining income, subject to GILTI, received both a deduction (initially 50 percent) and an offset worth 80 percent of foreign taxes paid. The deduction meant that the US tax rate on GILTI was lower than the rate on US income, reflecting the fact that it was earned abroad and is not an ordinary part of the tax base. The 50 percent deduction under § 250, therefore, functionally turned the 21 percent corporate income tax rate into a 10.5 percent rate on GILTI. (The deduction was scheduled to decline to 37.5 percent in 2026, yielding a 13.125 percent rate.) Actual foreign taxes paid, moreover, yielded foreign tax credits, and 80 percent of their value could be applied against GILTI. The system was far from perfect, but it was designed to tax CFCs’ income to the extent that it was “undertaxed” abroad, potentially (but not always) indicative of US tax avoidance rather than genuine economic activity in other countries.
Unfortunately, when states incorporated GILTI after the enactment of the TCJA, parts of this system immediately fell apart. The federal provisions were not adopted with states in mind, and states’ corporate apportionment rules weren’t designed to handle foreign income.
The foreign taxes generating the federal credits were paid by the foreign corporations that US-based multinationals owned or in which they had a substantial investment stake. As a pure matter of accounting, if the US shareholding entity is to be treated as having paid those taxes itself, an equivalent share must also be included in the company’s GILTI income, to avoid a double benefit. The 80 percent of credited taxes are first included in the US company’s income for GILTI purposes under the § 78 “gross-up,” and then the credit is applied. At the federal level, that all worked. But states rarely allow foreign tax credits, while they do conform to the gross-up, so their GILTI bases included 80 percent of the value of taxes paid by CFCs abroad, without the tax credits that gross-up was intended to facilitate. Rather than reducing tax liability based on foreign taxes having already been paid on the income, states’ GILTI regimes tax this income more because of the foreign taxes paid on it. The foreign taxes paid by the CFCs of corporations doing business in a state are not, of course, even remotely US corporate profits, which is what state corporate income taxes are intended to tax.
Converting to NCTI
For states, converting to NCTI makes the problem worse. To begin with, it eliminates the QBAI exclusion, bringing all the income of CFCs into the GILTI/NCTI base rather than just the “supernormal” returns. At the federal level, this base expansion is substantially offset through other changes, but for states, some of them turn into tax multipliers instead. Additionally, under NCTI, the § 250 deduction (which had been at 50 percent but was scheduled to fall to 37.5 percent in 2026), is made permanent at 40 percent, which has the effect of increasing states’ effective rates on this broader base.
But NCTI changes far more than this. Previously, under the GILTI regime, many expenses by US-based multinationals were sourced to their CFCs to the extent that they were deemed to benefit them. Since these business expenses would have ordinarily been deductions from the US company’s taxable income, these expense allocation rules (1) increased US tax liability for US-based multinationals, since they were denied deductions for some of their business expenses; but, at the same time, (2) provided deductions for the CFCs, reducing their taxable income potentially subject to GILTI.
On net, businesses would have preferred to have the deduction for their US-based corporations, as the ordinary rate is higher than the GILTI rate and because foreign taxes paid on ordinary business activity of CFCs abroad often yield credits in excess of GILTI tax liability, leaving some credits unused. (GILTI is, after all, a minimum tax. Foreign tax liability can often exceed its minimum.) Under NCTI, changes in expense allocation rules mean that more of these deductions are taken by the US parent corporation. Consequently, there are fewer deductions for their CFCs, yielding a larger NCTI base than the old GILTI base. That’s a welcome shift for many corporations with significant tax liability in other countries, because they get the benefit of the US deductions and can use more of their foreign tax credits against the new NCTI base. Simultaneously, the new law reduces the limitation on foreign tax credits (called the “FTC haircut”), raising the inclusion amount from 80 to 90 percent with a commensurate increase in the § 78 gross-up.
It’s not hard to imagine where this goes wrong at the state level. The NCTI base expands yet again, and the greater allowance for foreign tax credits, rather than offsetting liability, is picked up as additional income to be taxed. All four major changes—scrapping the QBAI exclusion, adjusting the § 250 deduction, trimming the FTC haircut with a commensurate increase in the § 78 gross-up, and revising expense allocation rules—make state taxation of NCTI more aggressive than state taxation of GILTI, whereas these changes yield a net tax cut at the federal level.
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