IRC Conformity Finally Arrives For Arizona And Minnesota, With Exceptions

Summary

Minnesota is one of four states that has not conformed with (or decoupled from) any of federal tax reform since the enactment of the law known as the Tax Cuts and Jobs Act in December 2017.  And while Arizona did enact limited Internal Revenue Code (IRC) conformity legislation in 2018, it only conformed to those pieces of federal tax reform that were effective for tax years ending on or before December 31, 2017.  Budget bills enacted in Arizona and Minnesota in late May update each state’s general IRC conformity date and also enact state tax code provisions that conform with (and decouple from) other specific provisions of federal tax reform.   
 

Details

Background
Arizona and Minnesota are both “fixed-date” IRC conformity states.  That is, like 21 other states, both conform to the IRC for purposes of applying their state income tax laws as of a specific date.  For example, prior to Minnesota’s recent enactment of its 2019 budget bill, Minnesota conformed to the IRC as amended through December 16, 2016, for corporate and personal income tax purposes.  Arizona and Minnesota have now updated their general IRC conformity dates to conform to some of the 2017 federal changes, while also decoupling from other specific features of federal tax reform. 

To date, California, New Hampshire, and Texas are the only states with income taxes that have not responded to any aspect of federal tax reform.
 
Arizona
On May 27, 2019, Arizona enacted H.B. 2757, which updates Arizona’s IRC conformity date and includes some decoupling from specific IRC sections enacted as part of federal tax reform.  In 2018, Arizona enacted an IRC conformity update, but it generally only conformed to those provisions of federal tax reform that were effective for tax years beginning during 2017.  As a result, Arizona has not conformed to any part of federal tax reform that was effective for tax years beginning after December 31, 2017, until now. 

For tax years beginning from and after December 31, 2017, through December 31, 2018, Arizona now conforms to the IRC in effect on January 1, 2018.  For tax years beginning from and after December 31, 2018, Arizona conforms to the IRC in effect on January 1, 2019, including those IRC provisions that became effective during 2018.  This legislation results in retroactive Arizona conformity to federal tax reform for 2018 tax years for Arizona corporate and personal income tax purposes.
 
Corporate Income Tax Changes
The Arizona legislation amends the Arizona foreign source dividend received deduction (DRD) to include as dividend income the IRC Section 78 gross-up amount, IRC Section 951A GILTI, and subpart F income (“as defined in Section 952 of the Internal Revenue Code”).  Prior to this amendment, the Arizona foreign source DRD simply applied to “[t]he amount of dividend income from foreign corporations.”  While expanding the type of foreign source income to which the DRD applies, the amendment only applies to taxable years beginning from and after December 31, 2018.  Thus, the amended Arizona foreign source DRD is not applicable to 2018 tax returns.     

Arizona corporate taxpayers will be required to add-back the IRC Section 250(a)(1)(B) GILTI deduction and the IRC Section 245A foreign-source DRD (otherwise eligible for the Arizona DRD) to the federal taxable income starting point when calculating Arizona taxable income.  However, these addition modifications are likewise applicable to taxable years beginning from and after December 31, 2018.

As a result, given H.B. 2757’s IRC conformity update, if GILTI cannot be treated as a foreign dividend under Arizona’s foreign source DRD applicable to 2018 tax years, then the net GILTI amount is included in Arizona taxable income for the 2018 tax year (based on Arizona’s federal taxable income starting point, the GILTI deduction should be applicable for Arizona corporate income tax purposes for 2018 tax years only).  Beginning with 2019 tax years, the gross amount of GILTI income qualifies for the amended Arizona foreign source DRD, while the GILTI deduction becomes an addition modification for Arizona corporate income tax purposes.    

The legislation does not decouple from (nor does it modify Arizona’s full conformity to) IRC Section 163(j) or IRC Section 168(k).  Thus, Arizona conforms to the federal business interest expense limitation and federal 100-percent bonus depreciation. 
 
Personal Income Tax Changes
For personal income taxes, H.B. 2757 reduces the number of tax brackets from five to four, reduces rates, increases the standard deduction, and revises the Arizona charitable contribution deduction, including a modified deduction for taxpayers electing the standard deduction.  The corporate income tax DRD for foreign source dividends, including GILTI and subpart F income, is not provided for Arizona personal income tax purposes.  
 
Minnesota
On May 31, 2019, Minnesota enacted H.F. 5, which updates Minnesota’s December 16, 2016, IRC conformity date and addresses a number of the new IRC sections adopted as part of federal tax reform.  Under H.F. 5, Minnesota updates its IRC conformity date to the IRC as amended through December 31, 2018.  The update is “effective retroactively at the same time the changes became effective for federal purposes.”
 
Corporate Income Tax Changes
The Minnesota State Legislature voted to not retroactively tax IRC Section 965(a) income or IRC Section 951A GILTI.  Both IRC Section 965(a) income (deferred foreign income) and IRC Section 951A GILTI will be treated as subtractions from federal taxable income for both Minnesota corporate income tax and personal income tax purposes.  The subtraction for GILTI income is effective for tax years beginning after December 31, 2017, and the subtraction for deferred foreign income is effective retroactively to the effective date of IRC Section 965 for federal purposes.  However, the IRC Section 965(c) deduction and the IRC Section 250 GILTI and FDII deductions are treated as additions to federal taxable income for Minnesota corporate income tax and personal income tax purposes. 
 
Another provision inserted into the legislation treats an inclusion in federal gross income under IRC Section 951 as a dividend.  This change should help clarify that subpart F income qualifies for the Minnesota DRD, but is effective on June 1, 2019 (the day following final enactment). 
 
The IRC Section 163(j) business interest expense limitation was adopted by H.F. 5 retroactively to tax years beginning on or after January 1, 2018.  The legislation instructs corporate taxpayers to apply the limitation on a combined reporting group basis: “The limitation must be aggregated between combined report entities consistent with the application to a consolidated group for federal income tax purposes.” 
 
H.F. 5 also adopts the federal tax reform limitation on net operating losses.  Accordingly, a Minnesota net operating loss deduction is limited to 80 percent of a taxpayer’s Minnesota “taxable net income.”
 
The legislation also renews the Minnesota hospital tax, which was scheduled to sunset on June 30, 2019.  The hospital tax rate is reduced from 2 percent to 1.8 percent, but it is no longer scheduled to sunset.
 
Personal Income Tax Changes
In addition to those changes mentioned above, H.F. 5 enacted a number of Minnesota personal income tax changes.  Minnesota has been one of a handful of states to begin the computation of Minnesota taxable income with federal taxable income, rather than federal adjusted gross income.  H.F. 5 changes the Minnesota personal income tax starting point to a taxpayer’s federal adjusted gross income.  Among other effects this change will have on Minnesota taxpayers, the IRC Section 199A qualified business income deduction for owners of pass-through entities will not be available as a deduction for Minnesota personal income tax purposes.
 
H.F. 5 will reduce personal income tax rates for the second tier income tax bracket from 7.05 percent to 6.88 percent.  The legislation also makes changes to the standard deduction, enacts a special limited adjustment enabling some taxpayers electing the standard deduction adjusted amounts of some itemized deductions, and other amendments to exemptions and itemized deductions.   
 
Other States
The Texas Legislature adjourned its biennial 2019 legislative session without enacting an update to the Texas January 1, 2007, IRC conformity date.  Since the Texas franchise tax is imposed on a taxpayer’s margin (generally, gross receipts less costs of goods sold and compensation), federal conformity is not as directly significant for Texas franchise tax purposes as it is for those states imposing taxes on or measured by net income. 
                                                                                                                                                                            
The California State Legislature and New Hampshire General Court (legislature) are still in session.  California’s session runs until September 13, 2019, while New Hampshire’s ends soon on June 30, 2019.  California conforms to only select IRC sections on a fixed-date basis, which is currently the IRC as enacted on January 1, 2015, whereas New Hampshire currently conforms to the IRC “in effect on” December 31, 2016, for tax years beginning on or after January 1, 2018 (and the IRC “in effect on” December 31, 2015, for tax years beginning on or after January 1, 2017).
 

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