Analysis: AB 71 – Proposed Taxation of GILTI is Misguided Policy
A new bill to change California’s international tax system to fund programs for the homeless is advancing through the California legislature. Assembly Bill 71, known as the Bring California Home Act, conforms California’s tax law to the federal tax code to require certain California taxpayers to include in their taxable income 50% of global intangible low-taxed income (GILTI) and 40% of repatriation income of the taxpayer’s affiliated corporations.
One aspect of the bill, the state taxation of GILTI, has been a particularly complicated matter that faces difficulty in administration, possible legal issues, and challenges the principles of sound tax policy. In California, the GILTI provisions of AB 71 would undermine the state’s well-established taxation of international business, make business in California more costly, and implement poor state tax policy.
What is GILTI?
GILTI is a new category of income earned by controlled foreign corporations (CFCs) designed to discourage multinational corporations from shifting income from valuable intangible assets to CFCs based in low-tax countries. The tax, under Section 951A of the Internal Revenue Code, was enacted under the 2017 Tax Cuts and Jobs Act (TCJA). Section 951A requires U.S. shareholders that owns at least 10% of the value or voting rights in a CFC to include GILTI in its gross income for the taxable year. GILTI is generally income from profits on foreign assets of more than 10% of qualified business asset investment less interest expenses. As part of the GILTI calculation, IRC Section 250 allows a 50% deduction against the corporate tax rate of 21%. This results in a minimum tax rate of 10.5% and is designed to make GILTI an estimate of the income that has been shifted out of the United States. Taxpayers can also claim a credit of 80% of their foreign taxes paid on the income.
GILTI is a key component of the TCJA’s corporate tax changes. The TCJA reduced the top corporate income tax rate from 35% to 21%, and changed the U.S. international tax system from a worldwide tax system to a hybrid system that is between a territorial and a worldwide system. Under its previous worldwide tax system, the United States taxed multinational corporations on all of their global income, allowing for foreign tax credits, and the tax on foreign-source income of foreign subsidiaries was deferred until the income was repatriated. After the TCJA, the United States taxes domestic-source income and excludes dividends that domestic corporations receive from foreign subsidiaries in which they own at least a 10%. GILTI, however, then imposes a worldwide tax system for qualifying income to both offset the revenue loss from the corporate tax reductions and to address the possible tax base erosion from corporations shifting profits to low-tax jurisdictions in response to the territorial tax system.
AB 71
California, like many states, is a selective conformity state that requires legislation to conform to most federal tax law changes. AB 71 conforms California tax law to the federal GILTI provisions for tax years beginning January 1, 2022 and incorporations the definition of GILTI from Section 951A. It amends both the state’s Personal Income Tax Law and Corporation Tax Law to include income derived from a corporation that is part of a combined reporting group and has made a water’s-edge election, which takes into account only income sourced in the United States. (For a discussion of the water’s edge election, see How California Taxes International Income.)
For partnerships and non-corporate taxpayers with GILTI income derived from a corporation that is part of a combined reporting group and has made a water’s-edge election, the law requires that 50% of that income is apportioned to California using the same apportionment factor as is used for the combined reporting group. Corporate taxpayers that make a water’s-edge election must include 50% of the GILTI of their affiliated corporations, but not the apportionment factors. It also limits the amount of business credits that a water’s-edge taxpayer may use to reduce any additional tax liability resulting from the provision to $5 million for certain tax years.
AB 71 would allow a corporate taxpayer to revoke a water’s-edge election and use worldwide combined reporting for calendar year 2022 if the taxpayer includes GILTI as required by the provisions. (A taxpayer would use this option if it thinks the 50% GILTI amount is too high.) Revenue from the changes would be used to fund homelessness programs.
California Should Not Tax GILTI
Proponents of state taxation of GILTI argue that it is a way to combat tax base erosion that has resulted from increased capital mobility, to reduce compliance and audit burdens, and to increase state tax revenue. The authors of AB 71 state that multinational corporations “have been shifting income out of the California corporate tax base for decades” and that conformity with GILTI is needed to “recapture lost revenue on an ongoing basis” and fund programs to help the homeless.
AB 71, however, raises issues related to California tax policy as well as general issues on the state taxation of GILTI. First, AB 71 would undermine California’s successful water’s-edge election and has the potential to raise international tensions. Also, AB 71 is simply a tax increase in the guise of conformity that would make business in California more costly. The proposed use of the GILTI tax revenue is also misplaced. Lastly, taxing GILTI exceeds the scope of state tax policy.
AB 71 would undermine California’s longstanding water’s-edge election. California taxes the foreign income of a “unitary group” through worldwide combined reporting with a single sales factor for apportionment. Since 1986, California has allowed corporations to elect to apportion income on a “water’s edge” basis, which restricts the combined reporting method to include only income sourced in the United States. This enables the state to tax multinational corporations on their income made in California while allowing taxpayers to avoid the burden of worldwide reporting. By taxing GILTI, however, California would undermine this policy to include income from CFCs in what would be a slightly modified form of worldwide taxation.
AB could raise international tensions. Prior to the enactment of the water’s-edge election, states used mandatory worldwide combined reporting. U.S. trading partners protested California’s and other states’ use of this method, and the U.S. government pressured the states not to use it. This pressure led to the adoption of the water’s edge election. Undermining this successful policy could reignite these international tensions.
AB 71 is simply a tax increase in the guise of conformity. GILTI was imposed to both offset the revenue loss from the reduction in corporate tax rates and to address the possible tax base erosion from corporation shifting profits to low-tax jurisdictions in response to the territorial tax system. Neither of these policy objectives hold for California. First, California does not conform to the federal corporate tax rate cuts and therefore has no policy reason to make up for the lost revenue. Second, the authors of AB 71 state that multinational corporations “have been shifting income out of the California corporate tax base for decades” and that conformity with GILTI is needed to “recapture lost revenue on an ongoing basis.” GILTI was implemented to address profit shifting that could result from the TCJA changes, not profit shifting “for decades.” Additionally, the federal policy to limit base erosion reduces the need for states to address the issue. AB 71 is simply a tax increase that does not follow either policy purpose of GILTI but is selective and arbitrary.
AB 71 would make business in California more costly. California has one of the nation’s highest corporate income tax rates, and AB 71 would make it even more costly to do business in the state. The high cost of doing business in the state and the continued threat of tax increase have driven corporate relocations. An increase in taxes will make it a more difficult business environment and could hurt the overall economy. The tax is also unfair, as businesses that are not involved in shifting profits could face an additional tax burden.
Tax revenue from GILTI should be used to fund California’s “rainy day fund.” Record tax receipts have resulted in a record budget surplus for California in the current year. (Governor Gavin Newsom estimated at $76 billion and state’s Legislative Analyst’s Office estimated at $38 billion.) However, the state faces long-term structural budget deficits that must be addressed. The state’s Legislative Analyst Office’s “Multiyear Budget Outlook” recommends that California use $12 billion of this windfall to restore the state’s fiscal reserves to help balance against California’s notorious tax revenue volatility. Tax revenue from taxing GILTI is likely to be pro-cyclical, meaning that tax receipts will increase when the economy is strong and decrease when the economy is weak. California should use any increase in tax revenues from the taxation of GILTI to fund the state’s “rainy day fund” rather than fund new spending programs.
GILTI exceeds the scope of state tax policy. California’s conformity to GILTI will radically expand the state’s taxation of foreign-source income.[10] While the federal government is moving from a worldwide tax approach to a quasi-territorial approach, the taxation of GILTI would expand California’s corporate income tax base to include more foreign-source income than ever before.
Additionally, California does not conform to the Section 250 foreign income deduction. The lack of the deduction means that all GILTI is subject to state corporate income tax, and the state will likely tax GILTI income at a higher marginal tax rate than the federal rate. This undermines the legislative goals of GILTI to penalize only low-taxed foreign-source income.