As you may know, President Trump signed into law the Tax Cuts and Jobs Act (TCJA), enacting broad reforms to the Internal Revenue Code. How your state implements these reforms may have an impact on project recruitment and retention. We have highlighted three changes to the code most likely to impact economic development:
- Section 118 – Many state/local incentives are now included in federal taxable income which reduces their value to projects. States that follow federal income tax rules may now tax state/local incentives, unless they decouple from federal income tax rules.
- Section 163(j) – Interest expense deductions are now significantly limited. This provides a significant competitive advantage for states that decouple and continue to allow unlimited interest deductions.
- Section 951A – A new tax was imposed on “GILTI” (global intangible low-taxed income applicable to controlled foreign corporations). In theory, this tax will encourage companies to keep their intangible income on-shore which could spur project activity.
Section 118 - Prior to the TCJA, capital contributions by a governmental entity to a corporate taxpayer were usually excluded from the definition of gross income under Section 118. Section 118 was amended to provide that contributions made by a governmental entity or civic group cannot be excluded as “contributions to capital,” unless the contribution was made pursuant to a master development plan approved by a governmental entity prior to December 22, 2017.
The modification of Section 118 was intended to “remove a federal tax subsidy for state and local governments to offer incentives and concessions to businesses that locate operations within their jurisdiction (usually in lieu of locating operations in a different state or locality).” By reversing the treatment of these contributions, money or property provided to a company by a state or local government may now be taxable at the federal (and possibly state) level.
This change likely only affects incentives that are viewed as a “contribution” such as cash grants, public infrastructure and improvement grants, no-cost land, reimbursements, and refunds. Other incentives, such as nonrefundable tax credits, deductions, abatements, and exemptions, likely do not constitute taxable income and should not be impacted by the new law.
Existing incentives could be restructured to avoid the risk that the incentive will be taxable. For instance, incentives that have been offered as grants in the past could be modified to provide the project with a nonrefundable tax credit in lieu of the cash grant. Similarly, tax abatements on property could be offered instead of no-cost land. Parties that have previously agreed to certain incentives could reevaluate them, but this may prove challenging since projects typically value the type of incentives that Section 118 now taxes more than the incentives that it does not. To do so, states and local governments may need to engage their respective legislatures to create viable alternatives that can be offered to the companies they seek to attract.
States are already amending their tax codes to decouple from the Section 118 changes. Georgia, Indiana and Tennessee have all amended their state statutes to decouple from the federal changes to Section 118. So, decoupling from Section 118 can now be construed as an incentive, i.e. choosing between states that have decoupled versus those that have not.
However, these changes should not apply to contributions made by a governmental entity after December 22, 2017, so long as the contribution “is made pursuant to a master development plan that has been approved prior to such date by a governmental entity.” The TCJA did not define a “master development plan,” and states have already responded with guidance in an attempt to minimize the impact of these changes. For example, legislation has been introduced in the District of Columbia that clarifies what approvals by the Council, Zoning Commission and other governmental entities constitute a “master development plan” for purposes of the Section 118 transition rule. Additionally, following the TCJA’s enactment, Florida also introduced legislation that provides an update to the state’s definition of “master development plan” for state and local tax purposes.
Those states not decoupling from the new Section 118 may need to be even more creative in their efforts to provide attractive incentives while accounting for the potential cost of additional federal and state income tax liability.
The TCJA contains new limitations on taxpayers’ ability to deduct interest expense for business debt. Previously, Section 163(j) disallowed a deduction for certain disqualified interest when the debtor’s debt-to-equity ratio exceeded 1.5 to 1 and the debtor’s net interest expense exceeded 50 percent of its adjusted taxable income. Now, Section 163(j) limits the annual interest expense deduction to the sum of business interest income, 30 percent of the taxpayer’s adjusted taxable income, and any floor plan financing interest. Although any disallowed interest expense may be carried forward indefinitely, this is a sea change in how interest expense can be deducted. The change does not apply to any business with average annual gross receipts not exceeding $25 million for the three-year period ending with the year preceding the one at issue. The net effect is to make debt financing more expensive for projects.
So, states decoupling from this new provision will arguably have an advantage over those following the new federal limitations. The decoupling front runners are again Georgia and Tennessee – both states have decoupled recently. Mississippi does not conform to Section 163(j) so it automatically decoupled.
GILTI Section 951A
The TCJA also imposes a special tax on global intangible low-taxed income, so called “GILTI” income, applicable to controlled foreign corporations (CFCs). These changes are designed to decrease the incentive for a U.S. company to shift corporate profits to foreign, low-tax jurisdictions and have generated a lot of press. GILTI will pass through to U.S. shareholders as a current year income inclusion. There is a reduced effective tax rate for GILTI of 10.5 percent, which increases to 13.125 percent after 2025.
Recently, as with Section 118 and 163(j), states have begun to decouple, but it’s more pervasive given its political implications. States that are considering decoupling include Georgia, Kentucky, North Carolina, Indiana, Connecticut, Michigan, Wisconsin, Hawaii, New Jersey, and North Dakota. South Carolina, Illinois, and Montana do not include GILTI in their corporate income tax base due to already existing decoupling provisions from the federal rules.
So, while the TJCA changes were not welcomed by all, they provide some states an opportunity to distinguish themselves in the recruitment and retention process. Decoupling from these changes can be seen as an indirect incentive in the market that would arguably apply to any entity subject to state income taxes. Policy-wise, a state is not necessarily picking winners and losers, as so often is the criticism of industry-specific incentives. The coming November elections will likely dictate just how many more states use this as a new tool for their economic development teams.