Given that it’s a presidential election year, much of the discussion among tax policy experts will focus on the candidates’ appetites for federal tax reform. But what often gets lost in that discussion is how changes at the federal level might affect the states. The reason for this is that most states in some way conform to the Internal Revenue Code.
When a state does conform to the IRC, it typically uses federal taxable income as the starting point for the state income tax calculation or conforms to various definitions contained in the IRC. Although most states conform to the IRC to at least some degree, many states decouple from various IRC provisions. Some common provisions from which states decouple are bonus depreciation, expensing of depreciable business assets (IRC section 179), and the domestic production activities deduction (IRC section 199).
There are three general methods by which a state conforms to the IRC: on a rolling basis, as of a fixed date, or on a selective basis. Conformity on a rolling basis means that a state automatically adopts provisions of the IRC as they are enacted. In terms of simplicity, this method may be preferable because taxpayers can rely on the date of the IRC provision enactment, and there is a more consistent application of the provisions across federal and state returns. Twenty-five states and the District of Columbia use rolling conformity.
States that use fixed-date conformity follow the IRC as it exists as of a specific date. Changes made to the IRC after that date (for example, January 1, 2014) would not be automatically incorporated until the state's legislature changes the conformity date. Unlike rolling conformity, which adopts IRC provisions automatically, affirmative legislative action is required to update the state's tax code to conform to the IRC as of a specific date. Twenty-one states use fixed-date conformity.
State conformity to the IRC encourages taxpayer compliance by eliminating the need for taxpayers to know the rules and procedures for both a federal system and a completely separate state tax system. State tax departments likewise rely on the federal system for administration of their income taxes. That reliance can be seen in how states conduct audits.
For example, when a state audits a corporate income tax return, it generally focuses on verifying whether the corporation properly apportioned its income across the states in which the corporation does business. The audit may also examine whether the corporation is a member of a unitary group or whether the corporation properly characterized some transactions or income. States don’t spend much energy examining whether the corporation properly determined its federal taxable income (generally the starting point on the state return). That task is left to the IRS, with states assuming that they will be notified if IRS auditors have determined that a corporation's taxable income must be adjusted.
Whether and how a state conforms to the IRC can also affect the state tax treatment of non-U.S. companies. For example, U.S. federal tax treaties may not protect international companies from U.S. state income taxes. Tax treaties to which the U.S. is a party apply only to federal taxes. They do not apply to any subnational (i.e., state or local) taxes.
This typically isn’t an issue if states use federal taxable income as the starting point for the state income tax calculation. Federal taxable income takes into account the concepts of permanent establishment provided for in an applicable tax treaty. If the state conforms to federal taxable income, a foreign corporation with no federal taxable income should also have no state taxable income.
The converse of this, however, is that if a state does not conform to federal taxable income, it may disregard the concepts of PE provided for in a treaty and determine on its own whether the foreign corporation has nexus with the state.