How Real Estate Companies Can Use Consolidate to Reporting to Pay Less Taxes
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After the introduction of the Tax Cuts and Jobs Act of 2017 (TCJA), the widespread opinion was that the United States had finally shifted from a worldwide tax regime to a territorial one, in line with that of its trading partners. It would be more accurate to say that the U.S. federal income tax system is now, at least, a blended regime.
According to thetaxadviser.com, the worldwide taxation model has, however, been actively used in several states, although not necessarily resembling the global federal reporting regime. About half of the States that require reporting on this type of income tax, require combined reporting.
We will focus here on the mechanisms of the State reporting, and the elements taxpayers should consider before deciding whether to avoid it or elect it.
U.S. Federal and State ‘worldwide’ Reporting – Key Differences
U.S. corporations were previously taxed on their worldwide income, no matter where it was earned. If earnings were generated outside U.S. borders, the tax on these earnings was only due on repatriation, effectively creating a deferral. However, some foreign earnings were taxed immediately by the United States.
The TCJA is different in that domestic C corporations are generally not taxed on repatriated dividends. The TCJA Code does, though, still contain Subpart F rules, while also introducing global intangible low-taxed income (GILTI). The U.S. consolidated returns only include U.S. corporations. International tax provisions, whether applied pre- or post-TCJA, tax the income of foreign affiliates by linking it to domestic entities.
U.S. shareholders of controlled foreign corporations (CFC) are subject to GILTI on their share of the income they earn from the CFC which exceeds 10% of their return on investment. The passive incomes earned by a CFC is defined as Subpart F income. U. S. shareholders must declare Subpart F income even though it does not generate payable dividends to them. (refer Secs. 951 – 965).
The Unitary Business Principle
State level reporting on worldwide income has some distinctive differences, the first of which is the Unitary Business Principle. A taxpayer with 80% ownership of both vote and value may elect to submit a U.S. consolidated federal income tax return. A Sec. 1504 affiliated group is only inclusive of U. S. corporations. The relationship between the entities in the group is not examined.
Combined reporting is still required in some states, and taxpayers are therefore required to file under this method. This compulsory requirement has led to courts restricting its use in these states by setting a unitary relationship requirement. This is consistent with the view held by the courts that if a group of entities is to be taxed by a state as a single economic enterprise, it is a constitutional requirement that the members of that group make up a unitary business. The difference between federal affiliated group and a unitary entity, is that the former is determined only on quantitative analysis, while the latter is based on both a quantitative ownership assessment and a qualitative assessment for unity.
Analysing the relationships between affiliates constitutes the determination of unity. This analysis can take several forms – Tests or factors such as common ownership and control, horizontal or vertical integration, economic interdependence, value flow, and intercompany transactions. An apportionment formula is then applied to attribute a part of the income from the unitary business to a particular state. This has usually been made up of a ratio of property, in-state sales, payroll in its relationship to sales, and payroll in totality. Now, however, the state apportionment formula is more likely to utilize the sales factor only.
The worldwide combination method leads a state to tax on the income that has been apportioned to that state by the corporate tax entity and all its affiliates that are engaged in a unitary business, both foreign and domestic. However, in states that use a water’s-edge combined reporting method, foreign affiliates, and even U.S. corporations, are excluded from the group if the bulk of their business is conducted outside of the U.S.
Elective vs. Mandatory
Some states have worldwide filing as their default, but there are some that permit entities to elect to file on a water’s-edge basis. This is not as straightforward as it would seem though. California, for example, requires an originally filed return, while Montana requires the election to be made within a defined number of days at the beginning of the relevant tax year. This window could be closed before the tax preparer becomes aware of activities taking place in these states. Frequent review of activities and the state nexus of the member of the group of companies, is essential to ascertain the most appropriate filing methodologies applicable in the states where the new activities are occurring. It amounts to taxpayers needing to assess which filing method will hold more benefit – water’s edge or worldwide.
Choosing a worldwide filing means needing to meet the requirements for the entity to be included, just like it applies to other unitary combined filings. Generally, these requirements would be the same for U.S. entities. The requirements are:
- A common ownership entity or parent entity (usually 50%) needs to apply to the reporting entity;
- The reporting entity must not be included in a different group filing in the same state; and
- The entity must be part of a unitary business group.
Just as with general combined group filings, all unitary entities in the combined group need to be included for worldwide combined groups. Both the income and losses from all these entities are included in the return to get to the state taxable income. Income generated from foreign entities needs to be converted to dollars before completing this calculation.
Filing a Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, with the group’s federal consolidated return, makes it available for the income declared on the form to be analysed regarding the relative benefit or detriment from submitting a worldwide combined filing.
The worldwide combined filing applies the apportionment rule in the same way for foreign affiliates in the group. Sales, property and payroll of the foreign affiliates are reflected in the denominators of the factors, and are reflected in the numerators if they’ve had activity within the state. Transactions between members of the worldwide group are usually removed from both the sales factor and the tax base.What to Consider for the Election
In the lead-up to electing a particular filing method, it is advisable to consider which method is set as the default, and what the length of the election is if choosing to opt out of the default filing method. A worldwide filing is the default in California, and if a company elects water’s-edge filing, it would be in effect for 84 months. Conversely, in Connecticut, water’s-edge is the default filing method, but choosing worldwide filing would mean a 10-year term. Careful consideration needs to be given to the implications of this choice for the whole election term, as it may not be beneficial throughout the period.
The key consideration before electing a filing method is, usually, the relative profitability of the foreign operations compared to domestic operations. Electing the worldwide method, the entity would include the income, or loss, and the relevant apportionment of the unitary foreign affiliate entities. Bringing in additional income from foreign affiliates can be offset by the dilution of the apportionment factor. This, only, of course, presuming the property, sales and payroll of the foreign affiliates would increase the denominator of the apportionment ratios, which then reduces the amount of income allocated to the state.
State tax adjustments may also be affected by worldwide combined filing. Income tax calculations made by the states are made by adjusting or modifying the federal tax income. This is where worldwide combined filing may prove beneficial. Foreign dividends would be a good example of this. A general dividend deduction for any foreign dividends being included in income is applied by most states. This deduction may not always be the full equivalent of the reported dividends. Electing worldwide combined filing means the dividends may be eliminated because they are received from an entity from within the combined group.
Intercompany transactions also need scrutiny when deciding which filing method to elect. The transactions that take place between domestic and foreign entities, assuming they are not included in the combined group, are not eliminated in the water’s-edge filing method. Conversely, worldwide combined election will result in the transactions between members of the combined group being eliminated. This elimination of intercompany transactions may possibly impact on both the apportionment and the state tax base. The sales factor may also be diluted by including foreign affiliates. Where an integrated supply chain crosses over the U.S. border, the sales of the foreign affiliate may be made primarily to a U.S. company. Including this entity, then, would not increase the sales factor denominator, because the sales would be eliminated.
Eliminating intercompany transactions will possibly also have an impact on the state-related party addback provisions. The rules related to this addback are usually seen in the light of separate-company reporting states. Under these rules, deductions of certain intercompany expenses, such as interest or royalties, need to be added back to arrive at the state taxable income. In some combined reporting states, however, addback rules may also apply to a water’s-edge group and its foreign affiliates that are excluded from the group. To avoid the addback, worldwide filing may be beneficial if there is concern about meeting the exceptions for the addback requirement.
To illustrate, here is an example and analysis of whether a worldwide combined election would be beneficial. We examine here whether including a foreign affiliate might create a loss for state tax purposes.
Three entities, Corp. X, Corp. Y and Corp. Z, all form part of an affiliated group, XYZ. X and Y file a federal consolidated return. As a foreign affiliate, Z is excluded from this return and the state’s water’s-edge filings. X’s taxable income is $1 million. Y shows a loss of $500,000. Z displays a pro forma loss of $750,000. The assumption in this example is that the state taxable income is equal to the federal taxable income. The taxable income on the water’s-edge filing amounts to $500,000. Electing worldwide combined filing would result in an overall loss of $250,000 for the group, and would be beneficial, regardless of the impact on apportionment.
A more complex example uses profitable foreign entities to illustrate the point. The analysis in this instance involves weighing the additional income included in the worldwide combined group against the effect the foreign affiliates have on apportionment.
Affiliated group XYZ, as described in Example A, files a state return with a 5% tax rate and a single-factor sales apportionment. Here, Corp. Z shows $250,000 income. The domestic entities show $3 million in-state sales and $10 million total sales. $8 million total sales is shown by the foreign affiliate, all from within its local jurisdiction. A water’s-edge return would show the income of the combined group as $500,000, with an apportionment factor of 30%. This then results in $150,000 state income. A worldwide combined filing would show the group’s income as $750,000, but a reduced apportionment factor of 16.67%, resulting in $125,000 state taxable income. This scenario shows how the additional income included in the worldwide return is offset by the dilution of the apportionment factor.
If, in the same example, Z has total sales of only $2 million, still fully within its local jurisdiction, the worldwide election would not be beneficial. Although the worldwide group’s income remains the same at $750,000, the apportionment factor increase to 25%, which makes the state taxable income $187,500.
It’s the relative profitability of the U.S. operations of a business compared to the relative profitability of operations outside the U.S. that determines the potential benefit of a worldwide filing. Marginally different profitability levels between entities inside the U.S. vs outside the U.S. should lean the election towards a worldwide filing, as it is more likely that state taxable income can be diluted with marginally less profitable apportionment factors, usually the sales factors.
Where the marginal profitability are reversed, a water’s-edge filing may be more beneficial. When analysing the impact of filing water’s-edge vs worldwide, an assessment of the likely future profitability between domestic and foreign operations should be done. It should also test what impact will be made by eliminating intercompany transactions, dividends from foreign entities, and whether either scenario includes these in the state tax base, as well as the possible impact of state addback rules.
Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.
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