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There has been much discussion on the Tax Cuts and Jobs Act (“TCJA”) and the impact on the Internal Revenue Code (“IRC”). A summary of the more significant changes set forth in the TCJA prepared by Zaino Hall & Farrin LLC can be viewed here. Few commentators have opined on how the TCJA provisions will impact Ohio taxes because Ohio does not have a state administered Ohio corporate net income tax. As we will discuss below, Ohio taxes may still be impacted by the TCJA provisions and it is important for Ohio taxpayers to consider these changes.
The income tax chapters in the Ohio Revised Code adopt the IRC as of a certain date. Therefore, any changes made to the IRC after the last date of the Ohio legislature’s last conformity legislation are not considered a part of Ohio law until new legislation is enacted updating the date of Ohio’s conformity to the IRC. The Ohio Revised Code currently adopts the IRC as of February 14, 2016. At this time, Senate Bill 22, the IRC conformity bill, has been passed by the Ohio General Assembly. Ohio Senate Bill 22, if signed by Governor Kasich, will incorporate the IRC as of the date of enactment into Ohio law. It is anticipated that the bill will be signed by Governor Kasich by year end. This article assumes that Senate Bill 22 will be signed by Governor Kasich without any line item vetoes.
Municipal Net Profit Tax
Ohio does not have a state administered Ohio corporate net income tax. However, Ohio has over 540 local taxing districts that impose a net profit tax on business entities. As a result, the municipal taxing regime might create the most questions with respect to the adoption of the TCJA provisions.
The Ohio Municipal Net Profit Tax regime is a complex blend of Ohio law, local ordinances, and regulations established by municipalities and third-party taxing administrators. Over the last 15 years, the Ohio General Assembly has enacted legislation set forth in Chapter 718 aimed at promoting uniformity across the municipalities. There is currently litigation about the General Assembly’s authority to enact laws in such areas. As a result, there is some question as to whether a municipality is required to specifically adopt the current version of the IRC by ordinance or whether the conformity legislation adopting the IRC in Chapter 718 (which adopts any conformity updates in Chapter 5700 of the Revised Code) is sufficient to adopt the IRC. It is currently unclear whether Ohio municipalities will specifically adopt, or decouple, from the most recent changes to the IRC. If no action is taken by the Ohio municipalities, then taxpayers may be able to assert that certain provisions, such as including Subpart F income from the deemed repatriation of foreign earnings in federal taxable income and the interest expense deduction limitation, are not included in computing the taxpayer’s net profit tax base.
Making the matter more complex, a business taxpayer may elect a new state administered Municipal Net Profit Tax beginning in taxable year 2018. The state administrated Municipal Net Profit Tax is set forth in R.C. 718.80 - 718.95 but is intended to mimic the other uniformity provisions in R.C. 718.01 - 718.60 and 718.99. Assuming the conformity language in Senate Bill 22 is enacted by year end, R.C. 718 will adopt the TCJA. It should be noted that there is litigation ongoing regarding whether the state administered Municipal Net Profit Tax is appropriate under the Ohio constitution. Furthermore, the municipalities may challenge the imposition of the new state administered Municipal Net Profit Tax if the provisions of the centralized collection law (R.C. 718-718.95) provide a different result than is available under the local ordinance. Thus, the analysis discussed below specific to a municipality conforming to the IRC is also applicable to those taxpayers that elected to opt-in to the state administered Municipal Net Profit Tax.
Presuming that the Ohio municipalities conform to the most current version of the IRC, the most significant concern for the Municipal Net Profit Tax is how the one-time repatriation of foreign earnings will be treated. The foreign earnings that are deemed to be repatriated will be treated as Subpart F income. IRC section 965(a). While Subpart F income is commonly referred to as a “deemed dividend,” at least one United States Court of Appeals has concluded that Subpart F income is not an actual dividend. Rodriguez v. Commissioner, 722 F.3d 306 (5th Cir. 2013). Subpart F income is included in Line 28 of Form 1120, which is the starting point for the Municipal Net Profit Tax calculation. See R.C. 718.01(E). As the Subpart F income is included in federal taxable income, a specific deduction would be needed to remove the Subpart F income from the Municipal Net Profit Tax base. If a taxpayer is required to include the Subpart F income in the Municipal Net Profit Tax base, it is unclear if the taxpayer will be permitted to include a corresponding amount in the sales factor denominator because Subpart F income is not necessarily “gross receipts of the business or profession during the same period from sales, rentals, and services….” See R.C. 718.02(A)(3).
A taxpayer may assert that Subpart F income is “intangible income” that should be partially deducted from the Municipal Net Profit Tax base. However, a municipality may assert that the Subpart F income is not “intangible income” because Subpart F income is not specifically listed in R.C. 718.01(S). Thus, there is potential that the one-time repatriation of foreign earnings will be taxed without apportionment factor representation by the Ohio municipalities. Taxpayers should evaluate their Ohio Municipal Net Profit Tax filings and consider the impact. Similar concerns exist for the federal base erosion provisions (i.e., the “BEAT” and “GILTI” taxes) that are also considered to be Subpart F income, subject to certain modifications, for federal income tax purposes.
Presuming that the Ohio municipalities conform to the most current version of the IRC, taxpayers will be subject to the interest expense deduction limitation, will lose the domestic production deduction (i.e., IRC section 199 deduction), will be limited for certain meal and entertainment deductions, lobbying deductions, and will be required to capitalize certain research and experimental expenses.
Historically, the Ohio municipalities have not decoupled from changes to the IRC. For example, the municipalities have typically allowed bonus depreciation, likely because the municipalities are permitted to tax depreciation recapture on the subsequent sale of the property. For taxable years beginning on or after January 1, 2017, all Ohio municipalities that impose the net profit tax are required to allow a five-year net operating loss (“NOL”) carryforward. With 100% bonus depreciation and the more favorable IRC Section 179 expensing provisions, some businesses may find that they cannot utilize their municipal net operating losses within the carryforward period.
TCJA repealed the nonrecognition of gains on the sale of relinquished tangible personal property exchanged for similar (referred to as “like-kind”) replacement property. Assuming the municipalities adopt TCJA and because the municipalities are permitted to tax depreciation recapture, taxpayers that operate like-kind exchange programs for personal property, such as automobiles or equipment leased to others, will be required to recognize income on the disposal of the relinquished property. The depreciation recapture may be significant if a taxpayer has continuously had a like-exchange program in place such that the relinquished property is almost fully depreciated. Some of these companies may not have filed municipal returns in the past due to significant tax losses and now may consider filing prior year returns to establish NOL carryforwards. The carryforward limits on NOL use in taxable years beginning on or after January 1, 2017 may also be an issue for such taxpayers. Another consideration is whether the taxpayer could recognize the depreciation recapture income in one year (rather than following the federal deferral period) to offset its expiring NOLs. Overall, many of these taxpayers will likely experience an increase in their Municipal Net Profit Tax liability.
Ohio Personal Income Tax
The Ohio Personal Income Tax (“PIT”) adopts federal adjusted gross income (“FAGI”) as the starting point in the calculation of Ohio taxable income. Many of the TCJA provisions alter the calculation of the federal personal income tax after the calculation of FAGI, such as the increase in the standard deduction, elimination of personal exemptions, and limitations on the state tax expense deduction. Thus, these federal changes should not directly impact an individual’s Ohio PIT.
One common Ohio PIT question is the Ohio treatment of the qualified business income deduction, a new federal deduction for individuals that have business income as a sole proprietor or through an interest in a pass-through entity. Taxpayers will not be able to claim the federal business deduction for the Ohio PIT because the TCJA updated IRC section 62(a) (which defines FAGI) to include the following sentence: “The deduction allowed by IRC section 199A shall not be treated as a deduction described in any of the preceding paragraphs of this subsection.” Thus, the qualified business income deduction (which is allowed by IRC section 199A) is not a deduction for purposes of calculating the FAGI amount. As the Ohio PIT uses FAGI as the starting point to calculate the Ohio PIT, the federal qualified business income deduction will not be allowed as a deduction for purposes of the Ohio PIT. However, taxpayers will continue to be eligible to claim the Ohio Business Income Deduction for qualifying business income earned as a sole proprietor or through an interest in a pass-through entity.
The TCJA contained additional provisions that impact the business income of an individual. The most common changes to consider are the bonus depreciation deduction and interest expense deduction limitation. Under current law, R.C. 5747.01(A)(20)(a), requires that five-sixths of the amount of depreciation expense permitted by IRC section 168(k) (i.e., bonus depreciation) and IRC section 179 expense be added back for the calculation of the Ohio PIT tax base. By adopting the current version of the IRC and under continuing Ohio law, Ohio will automatically decouple from the federal bonus depreciation and accelerated 179 expense provisions.
The new limits on business interest expense in the TCJA is a new federal tax provision and Ohio has not addressed whether the state will decouple from the federal tax provision. The limited proposed language available for Senate Bill 22 does not contain language that would decouple from the business interest expense deduction limitation.
The TCJA also contains some non-business provisions that may impact an individual’s FAGI and would, therefore, impact an individual’s Ohio PIT:
For separation agreements executed after 12/31/2018, alimony payments will no longer be deductible in the FAGI of the payor and included in FAGI of the payee.Rather, there is no deduction for alimony payments.
For most individuals, moving expenses will no longer be deducted for calculating FAGI.
Individuals that operate a sole proprietorship would also be subject to the Ohio law decoupling from bonus depreciation and accelerated IRC section 179 expense.
The TCJA also broadened the use of IRC section 529 plans. Under the new federal law, contributions to, and earnings from, IRC section 529 plans can also be used to pay private K-12 tuition expenses. Senate Bill 22, as currently drafted, should allow an exclusion for such expenses once the bill is enacted. Thus, an Ohio PIT deduction, up to $4,000 per a beneficiary, would be available to Ohio taxpayers for contributions to qualifying IRC section 529 plans for use for private k-12 tuition, as well as for college tuition. It is currently unclear whether any distribution made before Senate Bill 22 is enacted will qualify for exclusion for Ohio PIT purposes.
Ohio Pass-Through Entity Tax
The Ohio Pass-Through Entity (“PTE”) Tax is a tax that is imposed on pass-through entities with non-resident owners. The purpose of the PTE Tax is to place a withholding obligation on the pass-through entity. The PTE Tax would be impacted by Ohio’s adoption of the IRC. The Ohio PTE adopts the IRC as the starting point for determining whether the PTE is required to withhold. An election to file a Composite Return, which would include the personal income tax of each non-resident owner, also adopts the IRC as the starting point. The business tax considerations discussed above for the Ohio PIT would also be applicable to the Ohio PTE Tax and Composite Return.
To the extent a pass-through entity has federal income related to the foreign repatriation and/or anti-abuse changes, such income may be included in taxable income.
Ohio Commercial Activity Tax
While the TCJA did make changes to what is included in the definition of federal gross income under IRC section 61, the changes are not currently expected to significantly impact most taxpayers’ Ohio Commercial Activity Tax (“CAT”) liability. This is because the CAT is imposed on “taxable gross receipts,” not federal gross income, and the TCJA was primarily focused on deductions applied in calculating federal gross income. However, the CAT chapter specifically adopts certain provisions in the IRC and may follow the IRC in other situations where the CAT chapter uses a term that is only defined in the IRC. Some of the changes that may impact CAT taxable gross receipts include:
Narrowing the definition of IRC section 1221 assets to exclude certain self-created assets such as patents, inventions, models or designs, and secret formulas from the definition of a “capital asset” could increase taxable CAT gross receipts attributable to the sale of these self-created assets. The tax base for CAT purposes is based on “gross receipts” and allows for certain exclusions from the definition.Receipts from assets that qualify as IRC sections 1221 or 1231 property are excluded from the definition of “gross receipts” and, thereby are not taxable under the CAT.Thus, the receipts from the sale of these self-created assets would become subject to CAT (and sitused using a market type approach) unless another exclusion applies to the receipts.
Narrowing the definition of “contributions to capital” in IRC section 118 to exclude “any contribution in aid of construction or any other contribution as a customer or potential customer, and any contribution by any government entity or civic group….” may mean that certain incentives awarded by JobsOhio or Ohio municipalities (as well as similar incentives from other states) are taxable CAT gross receipts.An exclusion from taxable CAT gross receipts currently exists for “contributions to capital.”This phrase is not defined in the CAT chapter.The CAT chapter adopts definitions set forth in the IRC where not defined in the CAT chapter and where the term is used in a comparable context in the IRC.Like the TCJA, these incentives and similar contributions to capital may become taxable for CAT purposes.
Limiting like-kind exchange treatment to real property transactions may result in additional taxable CAT gross receipts.There is litigation pending on whether the sale of certain leased property is taxable for CAT purposes and whether the sale of property that is not taxable for federal income tax purposes pursuant to IRC section 1031 is taxable for CAT purposes.The change in the scope of property eligible for deferral under IRC section 1031 may cause these receipts to be subject to CAT.There may also be issues in terms of timing.For example, the TCJA allows the gains on relinquished property to be spread over time. It is unknown if the Ohio CAT law will allow the same deferral period.
One of the biggest areas of concern from a state tax perspective is the appropriate treatment of the one-time repatriation of foreign earnings and other anti-abuse provisions, which is a significant dollar amount for many companies. Because the CAT is imposed on an extremely broad definition of gross receipts, it seems likely these amounts will be included in the general definition. It is less clear whether such amounts qualify for an exclusion from the CAT base. Since the CAT is only imposed on Ohio taxable gross receipts, intuitively it may be difficult for the Ohio Department of Taxation to assert that these receipts (which stem from foreign activities) are properly sitused to Ohio. However, there is no direct authority available and taxpayers should consider their own specific facts and circumstances.
The question of whether CAT gross receipts adopts the IRC definition of an “amount realized” or an amount recognized in “gross income” for federal income tax purposes is also currently being litigated and the answers may be different depending on a taxpayer’s facts. Likewise, there may be additional situations where a CAT term will be interpreted based on a definition in the IRC. Many of the examples above are based on current pending litigation or controversy. Thus, each taxpayer should evaluate the federal changes under the TCJA (particularly changes in line 1 of the federal tax return: sales and gross income) to determine whether the federal change will also impact its CAT liability.
Ohio Credits and Incentives
Ohio credits and incentive programs should not be directly impacted by the TCJA. Under prior law, many taxpayers asserted that credits and incentive programs awarded by a state or locality were “contributions to capital” within IRC section 118 and, thereby, not taxable for federal income tax purposes. Ohio taxpayers may be impacted by the change to IRC section 118 that specifically excludes “any contribution in aid of construction or any other contribution as a customer or potential customer, and any contribution by any government entity or civic group…” from the definition of a contribution of capital. As a taxpayer can no longer claim that these items are contributions of capital, an individual income taxpayer would now be required to include contributions as part of federal taxable income.
At this point, it is unclear what types of credits and incentives would be considered taxable and the Internal Revenue Service has not provided any guidance. Incentives that would likely be taxable include: refundable tax credits, cash grants, land or equipment given to a business, certain land improvements made on a business’s property, and cash reimbursements. Incentives that would likely not be taxable include: nonrefundable tax credits, deductions, abatements, exemptions, and rate deductions. Taxpayers should be mindful of the changes to IRC section 118 as the taxpayer pursues credits and incentives packages in Ohio.
If Ohio conforms to the current version of the IRC, then Ohio taxes will be impacted by the TCJA provisions. While most taxpayers will be impacted by the TCJA provisions, one key question is how the Municipal Net Profit Tax will be impacted by the TCJA provisions and if the one-time repatriation of foreign earnings could be taxed by the Ohio municipalities. For companies with foreign operations, the potential increase in the Municipal Net Profit Tax liability could be significant. Taxpayers should carefully review their Ohio tax filings and facts and circumstances to understand the potential impact.
If you have questions on the TCJA, Ohio legislation to conform to the Internal Revenue Code, or the potential impact to Ohio taxes, please contact Tom Fagan, Debora McGraw, Adam Garn, or any one of the other professionals at Zaino Hall & Farrin LLC.
1 However, some municipal ordinances may not tax depreciation recapture.
2The nonrecognition provisions in IRC Section 1031 will continue to apply to real property. Thus, in some situations there were also be questions of whether the property is considered real property eligible for nonrecognition treatment or tangible personal property.