Connecticut Enacts Mandatory Unitary Combined Reporting
On June 30, Connecticut Governor Dannel Malloy signed the State’s biennial budget legislation. The legislation results in significant changes to the State’s corporate income tax by requiring mandatory combined reporting for unitary businesses, limiting the use of net operating losses and credits, and extending the corporate tax surcharge. The combined reporting provisions were originally slated to take effect retroactively to years beginning on or after January 1, 2015. However, the legislation was uniformly criticized by the corporate community. As a result, the legislation was amended and the effective date of the combined reporting provisions was postponed until January 1, 2016.
New Combined Reporting Rules
The new rules require corporate taxpayers to file on a combined basis with their unitary affiliates that are commonly owned. For this purpose, common ownership exists where a common owner(s), whether corporate or otherwise, directly or indirectly owns more than 50% of the voting control of each member of the group, regardless of whether the owner is a member of the combined group. A unitary business is defined as a “single economic enterprise which is sufficiently interdependent, integrated or interrelated through its activities so as to provide mutual benefit and produce a significant sharing or exchange of value among such entities, or a significant flow of value among the separate parts.”
The combined group can elect to have combined group income determined on a world-wide basis or an affiliated group basis. The election is effective only if made on a timely filed original return, and is binding for the year of the election and the next 10 years. If an election is not made, combined group income is determined on a water’s-edge basis.
Water’s-Edge Combined Group
Under the default rule, members of a unitary business are required to compute combined net income on a water’s-edge basis. Such return must include the following companies:
(i) a corporation incorporated in the US, unless such member has 80% or more of its property and payroll factors located outside the US;
(ii) a corporation, wherever incorporated, if 20% or more of its property and payroll is located in the US;
(iii) a corporation that earns more than 20% of its gross income, directly or indirectly, from intangible property or services, the costs of which are deductible for federal income tax purposes against the income of other members of the group, but only to the extent of the income and apportionment factors related thereto; and
(iv) a corporation incorporated in a jurisdiction that is determined by the Commissioner to be a tax haven, unless it is incorporated therein for a legitimate business purpose.
The legislation requires the Commissioner to publish a list of tax havens by September 30, 2016.
Affiliated Group Election
Under the affiliated group election, all members of the affiliated group, as defined in Internal Revenue Code Sec. 1504, must be included in the affiliated group return. The affiliated group also includes any domestic corporation that is commonly owned by any member of the affiliated group, without regard to whether the group includes corporations that are in more than one federal consolidated return, the corporations are operating separate unitary businesses or the corporations are not unitary with any other member of the affiliated group. Finally, similar to the water’s-edge methodology, an affiliated group also includes any member of the group incorporated in a tax haven, unless the Commissioner determines that such member is incorporated in the tax haven for a legitimate business purpose.
By including domestic corporations that are “commonly owned” by any member of the federal affiliated group, it appears that the legislature intended to expand the Connecticut affiliated group to include corporations that meet the more than 50% common ownership requirement. As a result, the Connecticut affiliated group may differ from the federal consolidated group.
A world-wide combined group includes all members of the unitary group under common ownership, regardless of the location of incorporation.
Computation of Net Income
A combined group’s net income is the aggregate net income or loss of each member of the combined group. The legislation generally follows the definition of net income used by separate filers (i.e., gross income, as defined in the IRC, less certain deductions set forth in CT Stat. Sec. 12-217). Each member of the combined group incorporated in the US and included in a federal consolidated return must compute net income as if such taxpayer filed separately for federal purposes. Non-US members that file separately for federal purposes compute Connecticut net income using federal taxable income as the starting point.
For members that are not incorporated in the US and not required to file a separate federal return, the income to be included in the combined return is determined from a P&L statement for each foreign branch or corporation in the currency in which the books of account are regularly maintained, adjusted to conform to GAAP and federal/state book-tax differences. The P&L statement and apportionment factors, whether US or foreign, are required to be translated to the currency in which its parent company maintains its books and records on any reasonable basis. Income is required to be expressed in US dollars. (Alternatively, any reasonable method for determining income in accordance with the rules contained in the State’s corporate income tax will be acceptable if consistently applied.)
Income from unitary pass-through entities is included in combined net income. In addition, intercompany dividends are eliminated, business income from intercompany transactions are deferred in a manner similar to federal Reg. Sec. 1.1502-13, and charitable expense deductions are computed based on combined group net income. Finally, capital gains and losses are combined before netting among classes, then apportioned and added to the income or loss of each member (any resulting apportioned capital loss must be carried forward by each member).
Once the composition and net income of the group is determined, each taxable member computes its own apportionment percentage under the rules applicable to that corporation (the legislation does not change the apportionment provisions) using combined denominators. Property and payroll denominators are determined using the factors of all members, not just members with apportionment ratios that include property and payroll factors. In addition, each taxable member will include a portion of the non-taxable members’ receipts assignable to the State. To determine this amount, each non-taxable member computes it receipts attributable to the State using the apportionment formula that would be applicable if the non-taxable member were subject to tax in the State. Each non-taxable member’s in-State receipts are then aggregated and apportioned to each taxable member based on each taxable member’s ratio of in-state receipts to total receipts of all taxable members. In computing the apportionment factors, intercompany transactions are eliminated.
Combined groups continue to pay tax on the higher of the income or capital base of tax. The capital tax is also computed on a combined basis, and includes the capital of non-taxable members, but inter-corporate stockholding are eliminated. For combined groups, the capital tax is capped at $1M.
Special Deduction for Deferred Tax Assets or Liabilities
Publicly traded unitary groups are allowed to claim a deduction if the new combined reporting rules result in a change to a taxable member’s deferred tax assets or liabilities. Specifically, beginning in 2018, the group may deduct from net income, each year for 7 years, an amount equal to 1/7 of the increase in a net deferred tax liability (or the decrease in a net deferred tax asset or the amount of a change from a net deferred tax asset to a net deferred tax liability), resulting from the imposition of the unitary reporting requirements.
Changes to the Utilization of Net Operating Losses
The legislation also modifies the utilization of net operating loss (“NOL”) carryovers. For years beginning on or after January 1, 2015, the net operating loss deduction for all taxpayers (whether or not filing on a combined basis) is limited to 50% of the taxpayer’s net income (or apportioned net income, if applicable).
For combined group losses generated after January 1, 2016, each taxable member carries over its share of the combined group net operating loss, and applies the limitation set forth above. Any remaining net operating loss deduction of one member of the group may be shared with another member, provided the taxable members were members of the combined group in the year the loss was generated. Special rules apply to the utilization of losses incurred prior to January 1, 2016. The legislation contains a special election for combined groups with unused (post-apportioned) net operating losses in excess of $6B from years beginning prior to January 1, 2013.
Changes to the Utilization of Credits
The legislation also changes the limitation on credit utilization. For years beginning on or after January 1, 2015, a taxpayer may claim a credit up to 50.01% of its tax liability (reduced from 70%). For combined groups, each taxable member separately applies the credit, and for years beginning on or after January 1, 2016, a taxpayer may share any remaining credit with other members of the combined group. As with net operating loss carryovers, different rules apply for credits earned in prior years or in years in which the corporation generating the credit was not a member of the combined group.
The legislation extends the 20% corporate surcharge for two additional years (through 2017). The temporary surcharge is reduced to 10% for years beginning in 2018. Companies that have less than $100M in annual gross income for such years are exempt from the surcharge. This exemption does not apply to taxpayers filing a combined return.
It is likely that the corporate community will continue to press for the repeal of the new combined reporting provisions and an increase in the allowances for NOLs and credits. Even if the provisions remain in effect, we expect taxpayers and practitioners to request revisions to and/or clarifications of certain provisions of the law, including the affiliated group election and the inclusion of tax haven corporations in the combined report. In the meantime, taxpayers should begin to review the impact of the new combined reporting laws to determine the best filing methodology for their group.
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