Proposed Regulation Addresses How Alabama Residents Calculate Credit for Taxes Paid to Other States

Last spring, the Alabama legislature stepped into the fray and resolved the issue of how resident owners of S corporations, LLCs, and partnerships should be taxed on their pro rata or distributive share of income earned by their company in other states. Act 2012-427, which was retroactively effective to January 1, 2011, requires Alabama residents who own pass-through entities doing business in two or more states to report on their Alabama income tax returns their entire pro rata or distributive shares of the pass-through entities’ worldwide income, but allows an income tax credit for certain taxes paid by the entities to other states either directly or on the owners’ behalf. The credit is available when the other state imposes an income tax withholding/composite return obligation or certain entity-level taxes on the pass-through entity. Resident owners can also claim a 50% credit for non-U.S. taxes paid on foreign source income. This legislation did not address how the tax credit should be calculated.

Prior to the passage of Act 2012-427, however, the Alabama Department of Revenue (the “Department”) revised its Schedule CR, the form on which the credit for taxes paid to other jurisdictions is calculated, to change the credit calculation. The change resulted in a substantial new limitation on the amount of credit available for taxes paid to other states. Because the tax credit had been calculated in the same manner for many years, and because there was no statutory or regulatory change that provided for the form change, this revision to Schedule CR created concern among a large number of Alabama taxpayers and their advisers. Many tax practitioners and their clients considered the form change to constitute an unauthorized rule change, in violation of the Alabama Administrative Procedure Act (“AAPA”).

On September 4—after months of discussions between a group of Alabama CPAs and other tax practitioners, the Department, legislative leadership, the Business Council of Alabama, and the Governor’s Office—the Department announced that it would withdraw the change to Schedule CR for the 2011 and 2012 tax years. Accordingly, for the 2011 and 2012 tax years, taxpayers may calculate the credit for taxes paid to other states using the pre-2011 methodology. The revised form is available on the Department’s website, at http://revenue.alabama.gov. The Department also issued a second announcement, clarifying its position on the Schedule CR and taxpayers’ filing options, in a very helpful September 12 Information Release, also available on its website.

In addition, and in light of the AAPA concerns, on September 30, the Department issued a proposed regulation that addresses how the credit for taxes paid to other states and to foreign jurisdictions will be calculated for tax years beginning on or after January 1, 2013. Prop. Ala. Admin. Code r. 810-3-21-.03. A copy of the proposed regulation is available on the Department’s website.

According to the proposed regulation, the credit for taxes paid to other states (or foreign countries) “shall only be utilized against that portion of the taxpayer’s income tax liability which is attributable to income from other jurisdictions.” Prop. Ala. Admin. Code r. 810-3-21-.03(1). The proposed regulation goes on to describe how the credit will be calculated, stating that:

As a general rule, that portion of a taxpayer’s income tax liability which is attributable to non-Alabama sources shall be determined by multiplying the taxpayer’s Alabama income tax liability before consideration of any credit described in Ala. Code § 40-18-21 by a fraction, the numerator of which is total non-Alabama source adjusted gross income and the denominator of which is total Alabama adjusted gross income.

Prop. Ala. Admin. Code r. 810-3-21-.03(2). The proposed regulation also provides an alternative formula to calculate the credit for taxes paid to foreign countries and provides useful examples of how both credits should be calculated.

On Wednesday, November 7, 2012 at 10:00 a.m., the Department will hold a hearing at its main office in Montgomery where concerned taxpayers and tax practitioners can comment on the proposed regulation. That hearing will be the last opportunity to submit comments on the proposed regulation, although comments may be submitted to the Department prior to the hearing.

Several members of our firm were involved in drafting the legislation expanding the credit for taxes paid to other states as well as in the negotiations regarding the credit calculation. If you have any questions regarding any of these matters, feel free to contact Chris Grissom, Will Thistle, or Bruce Ely of our SALT Practice Group or Dave Stewart, Senior Advisor for Government Affairs & Economic Development, in our Governmental Affairs Practice Group.