Typically, conformity with the Internal Revenue Code (IRC) aligns state tax codes with the federal tax code’s functions and purpose. However, when states conform to certain international tax provisions, they distort the federal provisions and their intent because they incorporate only portions of these international tax regimes, not the whole system.
In a paper released today, I outline how Oregon is already an outlier in taxing global income, and make the case that the state shouldn’t double down by adopting even more aggressive taxes on international business activity. I document the effects of these policies, explaining how they function economically like a tariff on multinational businesses’ sales into the state.
But this isn’t just an Oregon issue.
Consider the tax on net CFC-tested income (NCTI), to which some states, including Oregon, conform. At the federal level, this new tax is essentially a minimum tax, imposing a compensatory tax on income that is only minimally taxed abroad. The base begins with all income of a U.S. parent company’s foreign subsidiaries (controlled foreign corporations, or CFCs). They can then claim tax credits for 90 percent of the foreign taxes paid by those subsidiaries and apply a 40 percent deduction to what remains. Against a 21 percent corporate income tax, this yields a minimum tax of 14 percent. (In practice, due to several other adjustments, the floor is closer to 15 percent.) Essentially, U.S. tax applies to the difference between foreign tax paid and about 15 percent.
States, however, do not offer foreign tax credits, meaning that 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 foreign tax was paid on it. What functions as a minimum tax at the federal level turns into an aggressive state tax on U.S. companies’ foreign subsidiary income. It is not a guardrail against profit shifting; the mere existence of the federal tax already addresses that by making profit-shifting activity substantially less attractive or beneficial. Instead, at the state level, NCTI is primarily a state tax on the foreign production and sales of foreign companies simply because their U.S. parent company has nexus with the state.
The inversion of federal policy does not end there. It is bad enough that foreign taxes do not reduce state tax burdens on that same income. It is even worse that states that incorporate NCTI actually tax companies on the amount they paid in tax abroad.
Controlled foreign corporations (CFCs) pay the foreign taxes, but NCTI is imposed on the U.S. parent corporation. To make the math work, if the U.S. parent is provided a credit for taxes paid abroad by its subsidiaries, then it must include the amount paid in tax in its NCTI income to avoid a double benefit. The 90 percent of foreign tax payments credited against U.S. tax liability are included in the U.S. parent company’s income under a provision called the § 78 “gross-up,” after which the credit is applied.
Because states do not offer foreign tax credits, their tax base includes foreign tax payments. The federal base is the difference between foreign tax payments and about 15 percent. States’ NCTI bases are an apportioned share of all foreign subsidiary income (typically reduced by some deduction to yield a lower effective rate), plus those companies’ foreign tax payments, which do not benefit from that deduction.
State apportionment of NCTI has nothing to do with the state’s connection to the international activity. Instead, it is simply based on the state’s share of domestic activity. If 10 percent of related companies’ U.S. sales are in a state, then 10 percent of the foreign corporations’ revenues are included in the state’s base.
This primary result of state-level NCTI taxation is not higher tax burdens on foreign businesses, but higher prices for in-state residents.
Under states’ corporate income taxes, a company’s income is allocated to states based on three factors (payroll, property, and sales) for tax purposes. In many states, apportionment is based exclusively on the share of nationwide sales made into the state (“single sales factor”).
Consequently, the corporate income tax does not really tax net income. Rather, it taxes the apportionment factors located in the state. If payroll is in the formula, the corporate income tax is partly a tax on in-state labor. If property is included, the tax partly falls on in-state capital. And when sales are in the formula, that portion of the tax—all of the tax in the many states with single sales factor apportionment—becomes a tax on in-state consumption. Income sets the rate at which the factors are taxed, but the base is sales.
If taxes on international activity sufficiently increase a company’s in-state tax, they may be motivated to reduce their footprint in the state, since sales into the state may become uneconomical. This is particularly true for brick-and-mortar operations deciding where to locate physical stores. The result is reduced profitability for businesses with a physical footprint in the state, and lower employment within those businesses.
For sales made into the state regardless, these taxes have the potential to increase consumer prices. Consumers may not make the connection between higher prices or reduced consumer choice and obscure international income policies that drive up corporate tax effective rates, but they will be on the hook for much of the increase should these measures be adopted.
Online retailers already adjust prices based on factors such as the cost of selling in different markets. When a state’s corporate income tax regime increases the cost of selling into the state, prices of goods and services purchased online are likely to rise. Brick-and-mortar stores will factor these costs into their prices as well. Even if the product has no connection to international commerce, selling in the state expands the portion of international activity the state can tax.
When states tax international income, those provisions function like tariffs on sales into the state by any company that shares a corporate parent with these foreign companies. And just like conventional tariffs, a foreign company might write the check, but in-state consumers would foot much of the bill.
To read the full Oregon study, which is also pertinent to any other state that taxes NCTI or is considering other taxes on international income, like worldwide combined reporting, click here.
Cover photograph: Oregon State Capitol, Salem, by M.O. Stevens (2008). Public domain, via Wikimedia Commons.
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