After negotiations between the New Jersey Legislature and Governor Phil Murphy reportedly broke down, the New Jersey Senate released draft budget legislation aimed at closing an estimated budget shortfall by imposing tax on I.R.C. section 965 repatriation income and effectively increasing New Jersey’s tax rate to as high as 13%, which would make it the highest in the country. If enacted, we anticipate that large, multi-state corporations would see dramatic—often multi-million dollar—increases in New Jersey tax. After clearing the necessary budget committees in each chamber, the legislation is expected to be presented to both houses on Thursday, June 21. A quick overview of the legislation follows and a more detailed discussion appears below. We note that this Legal Update discusses the version of the bill current as of the time this was written. We expect there could be changes in the immediate future. The draft legislation:
- Does not include the mandatory unitary combined reporting or a shift to market-based apportionment sourcing, as has been suggested in recent months. Neither of those is addressed at all, so New Jersey would continue to be a separate reporting state with single sales factor apportionment measuring service receipts based on “where performed.”
- Would impose a two-year surtax on corporations with more than $1 million in federal entire net income (even if their New Jersey allocated taxable income is less than $1 million).
- Presumes I.R.C. section 965 repatriation toll charge amounts are included in taxable income and disallows related deductions (i.e., they are included at gross).
- Would impose a separate 9% tax on dividends, including deemed dividends, which suggests that I.R.C. section 965 income would be subject to this tax. Dividends would be apportioned to New Jersey at approximately 3%, regardless of source.
- Would expand the definition of “entire net income” to include income exempt from federal income taxation by application of federal income tax treaties.
- Would reduce New Jersey’s dividends paid deduction (effective January 1, 2019).
- Would apply the I.R.C. section 163(j) interest expense limitation.
- Would disallow the I.R.C. section 199A deduction for qualified business income from pass-through entities.
The Senate’s proposal addresses the potential budget shortfall by imposing significant corporate tax increases. However, the proposal has significant shortfalls of its own that should be addressed rather than rushing to pass legislation before the June 30 deadline.
Corporation Business Tax Surtax (Revenue RAISER)
The draft legislation adds a surtax on taxpayers (other than public utilities) subject to the Corporation Business Tax (“CBT”) with entire net income of more than $1 million, effective for the taxpayer’s first two CBT privilege periods ending on or after January 1, 2018. The surtax rate is either 2.5% (for taxpayers with entire net income of more than $1 million but less than $25 million) or 4% (for taxpayers with entire net income in excess of $25 million) and is imposed on allocated net income. The surtax cannot be reduced by applying business incentive credits.
The surtax provision does not define “allocated net income,” so we presume it is the amount allocated under the current CBT provisions (e.g., N.J.S.A. 54:10A-6). This would result in the surtax effectively being a tax rate increase such that corporations with entire net income between $1 million and $25 million would have a CBT rate of 11.5% (9% + 2.5%) and corporations with entire net income above $25 million would have a CBT rate of 13% (9% + 4%). This would make New Jersey the highest tax rate in the country—and double the tax rate of next-door neighbor New York, which lowered its corporate tax rate to 6.5% for most taxpayers in 2016.
As written, the language indicates that the determination of which surcharge rate applies is made based on federal entire net income, but then the rate is imposed on allocated New Jersey taxable income. Moreover, the surcharge is imposed as a “cliff” rather than on a graduated basis. Each of these, as well as the amount of the rate itself, raises several constitutional concerns.
Additionally, because the draft legislation would apply the surtax to the current tax year and requires estimated payments, corporations may need to adjust estimated payments if the surtax is ultimately passed to avoid potential underpayment penalties.
Federal Section 965 Repatriation Toll Charge and Dividend Tax (Revenue RAISERS)
The draft legislation presumes that I.R.C. section 965 “repatriation toll charge” income would be included in the New Jersey tax base. In fact, the Division of Taxation issued guidance indicating that the I.R.C. section 965 amounts were eligible for New Jersey’s DRD treatment, which varies based on ownership percentage. The legislation then expressly disallows any “deduction, exemption, or credit” for income reported pursuant to I.R.C. section 965 computing entire net income under the CBT. By disallowing any section 965 deduction, the draft legislation is requiring corporations to include all I.R.C. section 965 income without the benefit of the rate-effecting deduction found in I.R.C. section 965(c).
Like several provisions of federal tax reform, the repatriation toll charge was only one half of a pair of provisions intended to work in concert with each other: (a) the repatriation toll charge taxes (roughly) pre-2018 deferred offshore income at a reduced rate, while (b) deductions for distributed and undistributed foreign-sourced income exempts such amounts beginning in 2018. By adopting the income inclusion provision, but not adopting the deduction provision, New Jersey is not only imposing tax on foreign-source income that Congress has expressly exempted from US federal income taxation but is also doing so twice.
Of course, other provisions of New Jersey tax law specifically tie the New Jersey starting point to federal form 1120, line 28, which will likely not include I.R.C. section 965 income (which will be computed for federal purposes on a worksheet and then included in the tax line, but not in lines 1 through 28). Therefore, an argument can be made that the I.R.C. section 965 income is not included in the CBT tax base at all.
It should be noted that many states, including New York, enacted legislation or released guidance indicating that section 965 income would not be taxable in the state.
The draft legislation imposes a separate 9% tax on allocated dividends for tax years beginning on or after January 1, 2017 and ending before December 31, 2018. “Dividends” for this purpose include all actually paid and “deemed” dividends, as well as distributions “treated as dividends” by the Internal Revenue Code. By including “deemed” dividends in the definition of taxable “dividends” and imposing such tax from January 1, 2017 through December 31, 2018, the draft legislation is likely aimed at capturing amounts included in federal gross income by operation of I.R.C. section 965. However, the term would include more than just section 965 dividends.
Rather than allocating dividends to a corporation’s headquarters state and rather than looking to the actual activities that generated the dividends, dividends (including gross I.R.C. section 965 income) would be allocated to New Jersey by comparing New Jersey’s prior year nominal gross domestic product to the sum of the prior year nominal gross domestic product for all US states and territories, as well as the District of Columbia. That appears to be approximately 3%, using 2017 data. This means that a company headquartered outside of New Jersey with a business allocation percentage of only 1% based on its actual activities would be required to assign approximately 3% of its total dividends to New Jersey. This would be the case even for section 965 income, which is—by definition—non-US source income. This raises substantial constitutional concerns, with regard to both apportionment and discrimination.
The dividend tax applies to CBT taxpayers and taxpayers subject to New Jersey Insurance Premiums Tax or other insurance company tax that receive at least $1 million in dividends for the taxable year. The dividend tax is due on or before May 15, 2019 and may be offset by a credit for CBT that the same taxpayer actually paid on the same dividends that are also subject to the dividend tax.
Entire Net Income (Revenue RAISERS)
The draft legislation expands the definition of “entire net income” to a) include income exempt from federal income taxation by application of a federal income tax treaty unless such treaty expressly applies to states; b) reduce the New Jersey dividends paid deduction from 100% to 95% for dividends paid from 80% or more owned subsidiaries, effective for tax years beginning on or after January 1, 2019; c) apply the interest expense deduction limitation found in I.R.C. section 163(j); and d) disallow the deduction for qualified business income from certain pass-throughs found in I.R.C. section 199A.
By providing a modification for income exempt from federal income taxation by operation of a federal income tax treaty, the draft legislation appears to overturn the New Jersey Tax Court’s opinion in Infosys Limited of India, Inc. v. Director, Division of Taxation, which held that New Jersey’s statutory definition of entire net income did not allow for inclusion of treaty-exempt income. However, the draft legislation does not provide a specific inclusion of such income in the CBT apportionment provisions, which would be necessary to avoid potential constitutional infirmities.
The draft legislation’s application of I.R.C. section 163(j) expressly includes interest paid to related and unrelated parties in the limitation calculation, even if the related party interest expense addback also applies. Because the interest expense “counts” for purposes of the section 163(j) limitation and could also be added back, the draft legislation could result in interest paid to a related party being functionally included twice in taxable income.
New Jersey routinely ranks as one of the worst business climates in the country. At a time when many states are providing taxpayers with relief from the possible state-level implications of federal tax reform, New Jersey’s attempt to raise a substantial amount of revenue is an anomaly.
If enacted, many of the provisions contain significant constitutional infirmities that will result in years of litigation and corresponding expense to taxpayers and the state. Rather than enact messy stop-gap provisions, the New Jersey Legislature and governor should work with the business community to develop a better budget.