Included within the numerous provisions of P.L. 115-97, commonly referred to as the Tax Cuts and Jobs Act (TCJA), were amendments to the federal income tax expensing rules for research and experimentation (R&E) costs. Although the TCJA was enacted in 2017, these changes did not become effective until tax years beginning on or after Jan. 1, 2022.
These newly effective Sec. 174 amendments require taxpayers generally to capitalize and amortize domestic R&E costs over five years and foreign R&E costs over 15 years. The differing amortization periods were included in the TCJA in part to encourage R&E activities inside the United States. Prior to the amendments to Sec. 174, taxpayers could immediately deduct R&E costs in the year they were incurred or elect to capitalize and amortize those costs over 60 months. For taxpayers with significant R&E costs, these amendments can materially affect their federal tax liabilities.
The changes to Sec. 174 also present numerous issues for state corporate income tax purposes. The state effect of the changes depends on how states conform to the Internal Revenue Code. This item explores which states likely conform to the amendments to Sec. 174, which states likely decouple from those changes, and the issues raised by conformity to or decoupling from the changes.
Conformity to the Code
Generally, states conform to the Internal Revenue Code on either a “rolling” or “static” basis for purposes of computing the state’s tax base. A rolling conformity state generally adopts the provisions of the Code for purposes of its tax base computation as the federal government enacts those provisions. In other words, a rolling conformity state automatically conforms to the current version of the Code unless otherwise provided by state law. Currently, 23 states conform to the Code on a rolling basis.
A static or “fixed-date” conformity state generally conforms to Code provisions as enacted as of a specified date. Regardless of any subsequent federal changes, the Code as of the date specified by state law will continue to apply for state income tax purposes until state legislation is enacted to update the conformity date. Nineteen states currently conform to the Code as of a fixed date.
The exception to these two methods is “selective conformity.” States with selective conformity adopt specific Code provisions on a rolling or fixed basis. The most significant of the selective conformity states is California, which generally conforms to the Code in effect on Jan. 1, 2015, for the Code sections to which it conforms.
While most states conform to the Code on either a rolling or static basis for purposes of computing the tax base, it is common for states to selectively decouple from specific Code provisions. For example, even before the enactment of the TCJA, many states decoupled from federal special (bonus) depreciation under Sec. 168(k) and the federal deduction for state and local income taxes. With the enactment of the TCJA, a slew of new provisions were added to the Code. As a result, states began to selectively decouple from some of the new provisions. Whether through maintaining a pre-TCJA conformity date or through selective decoupling, as of March 2023, five states currently decouple from Sec. 174 as amended by the TCJA — California, Mississippi, Tennessee, Texas, and Wisconsin (see Cal. Rev. & Tax. Code §§17024.5(a) (1)(P), 23051.5(a), and 24365; Miss. Code §27-7-17(1)(f)(ii)1 (effective for tax years beginning after Dec. 31, 2022); Tenn. Code §67-4-2006(a)(11); Tex. Tax Code §171.0001(9); and Wis. Stat. §71.22(4)(L)). In March 2023, the Georgia Legislature passed legislation that would decouple from “new” Sec. 174 (Senate Bill 56).
Nonconformity to ‘new’ Sec. 174 and the resulting implications
As mentioned, California generally conforms to the Code as enacted on Jan. 1, 2015. Accordingly, for purposes of calculating the state tax base for California franchise (income) tax purposes, the changes to Sec. 174 contained in the TCJA enacted on Dec. 22, 2017, are not effective for California. Therefore, for California purposes, R&E costs may generally be deducted in the year they are paid or incurred, pursuant to the provisions of “old” Sec. 174 (the version of Sec. 174 in effect prior to Jan. 1, 2022) rather than capitalized and amortized (unless the taxpayer otherwise elects to capitalize those costs).
Similar to California, the provisions of “old” Sec. 174 also control for computing the tax base of the Texas franchise tax. This treatment results from Texas’s conforming to the Code in effect on Jan. 1, 2007. As a result, R&E costs deductible under “old” Sec. 174 may generally be deducted in the year paid or accrued for taxpayers that deduct costs of goods sold in computing their Texas franchise tax base.
Unlike California and Texas, Tennessee, Mississippi, and Wisconsin generally conform to versions of the Code that incorporate the changes effected by enactment of the TCJA. Nevertheless, these states have selectively decoupled from the provisions of “new” Sec. 174 (the version of Sec. 174 in effect beginning Jan. 1, 2022) and allow for the immediate expensing of R&E expenditures. Tax professionals should be cognizant of the practical implications of nonconformity with “new” Sec. 174 in these states and the related planning opportunities available for taxpayers with R&E expenses.
An indirect consequence of the inconsistent state-level treatment in nonconforming states is the increase in the recordkeeping responsibilities needed to account for R&E deductions. Taxpayers will need to track the difference between the state and federal treatment of Sec. 174 R&E expenses throughout the entire applicable amortization period (five or 15 years). Addback modifications for nonconforming states will also be necessary in the years following the year of the expense. The Tennessee Department of Revenue has issued guidance to this effect in Notice No. 22-03 (May 2022), noting that taxpayers will need to add back on their Tennessee excise tax return the federal deduction for R&E expenses reported on their federal income tax return for the tax year and subtract the R&E expenditures paid or incurred in the tax year.
In addition to the compliance considerations, nonconformity also presents planning opportunities. As alluded to above, “old” Sec. 174(b) allowed taxpayers to elect to forgo the immediate expensing of R&E expenditures in favor of capitalizing the cost and amortizing the expense over a period of not less than 60 months. Taxpayers with current low apportionment that is projected to increase in one or more of the decoupling states may elect, if the state allows for a stateonly election, to more closely follow the federal treatment under “new” Sec. 174 despite nonconformity. This could allow these taxpayers to (1) minimize the cost of tracking federal and state differences; (2) take the longer amortization to use up expiring tax attributes such as credits and net operating losses; or (3) defer expenses into years for which apportionment is expected to be higher. For purposes of how to treat R&E costs under the versions of Sec. 174 to which the states conform, it appears that California, Mississippi, and Wisconsin allow for state-only elections (see Cal. Rev. & Tax. Code §§23051.5(e) and (f); Miss. Code §27-7-17(1)(f)(ii)1 (effective for tax years beginning after Dec. 31, 2022); and Wisc. Dep’t of Rev. Tax Bulletin No. 220 (January 2023)).
Constitutional issues with state conformity to ‘new’ Sec. 174
The U.S. Constitution grants Congress the sole power to regulate interstate and foreign commerce. As a complement to that positive grant of authority, the U.S. Supreme Court has interpreted the Commerce Clause also to have a negative application that broadly prohibits states from discriminating against or unduly burdening foreign or interstate commerce. Notably, the Court, in Kraft General Foods, Inc. v. Iowa Department of Revenue, 505 U.S. 71 (1992), held that a state’s conformity to the Internal Revenue Code “in whole or in part, [does not shield it] from Commerce Clause scrutiny.” At issue in Kraft was the state’s definition of net income used to determine the state corporate income tax liability. Iowa conformed with the Code in part and, pursuant to that conformity, did not allow the taxpayer a deduction for dividends it received from certain of its foreign subsidiaries. In contrast, dividends from domestic subsidiaries were not included in the Iowa tax base. Unlike at the federal level, however, it did not allow a taxpayer to claim a credit for taxes paid to a foreign country. The Supreme Court held that including only foreign subsidiary dividends in taxable income clearly disfavored investment in foreign subsidiaries and facially discriminated against foreign commerce.
On the basis of Kraft — and other decisions from the Supreme Court and state courts — there may be an argument that a state’s application of the disparate amortization periods applicable to domestic and foreign R&E activities in computing the state corporate income tax base violates the Commerce Clause by discriminating against foreign commerce. Similar to Iowa’s conformity to the Code provision at issue in Kraft, which resulted in disparate treatment of domestic activities and foreign activities in violation of the Constitution, a state’s conformity to “new” Sec. 174 may violate the Constitution due to the state’s unfavorable treatment of foreign activities in comparison with domestic activities, because of the requirement to amortize foreign R&E expenses over a significantly longer period than domestic R&E expenses.
While the changes to Sec. 174 are seemingly straightforward on their face, how the changes interact with state tax codes and how they are applied (or not) for state corporate income tax purposes present certain challenges. Taxpayers should thoroughly consider the implications of the federal changes, as the interaction between the Internal Revenue Code and state tax codes presents not only compliance complexities but potential constitutional violations.