The budget reconciliation bill's replacement of global intangible low-taxed income with "net CFC tested income" will expand the amount of foreign income that can be subject to state tax without offering the higher amount of foreign tax credits that will be available at the federal level. Tax practitioners suggested that states that follow the new NCTI rules will risk running into more constitutional hurdles than they did when conforming to GILTI.
Since states don't take into consideration foreign tax credits, their provisions for taxing foreign-sourced income are different from computing federal taxable income.
The GILTI regime was one of a handful of international provisions in the 2017 Tax Cuts and Jobs Act that were intended to prevent companies from taking advantage of a new exemption on most foreign profits and migrating their intangible income offshore. But despite its name, the measure doesn't actually target intangible income. Rather, the law uses a proxy based on the percentage of income over tangible, depreciable assets.
According to the GILTI statute's mechanics, if the earnings of a controlled foreign corporation, or CFC, exceed 10% of its depreciable tangible assets, technically, its qualified business asset investment, that income, is pulled into the U.S. for taxation. But it also receives a 50% deduction under Internal Revenue Code Section 250, resulting in a 10.5% rate, compared with the 21% overall corporate tax rate.
Tax practitioners and business groups have been concerned about state taxation of GILTI and how state apportionment formulas don't properly account for the activities of CFCs that generated the income. States that don't provide any sales factor representation for GILTI can distort the amount of income that's subject to tax at the state level.
The NCTI rules, which take effect in 2026, broaden the tax base of the CFC-generated income and reduce some deductions, such as cutting the Section 250 deduction from 50% to 40%, while also loosening restrictions on foreign tax credits. But because states don't typically recognize foreign tax credits, states that conform to the new NCTI regime will expand the amount of international income they are taxing without the offsetting reductions that businesses can take at the federal level.
Currently, 21 states tax some portion of GILTI, according to a July 9 report from the Tax Foundation authored by Jared Walczak, the foundation's vice president of state projects. Fifteen states, including Colorado, New Jersey and New York, plus the District of Columbia, will automatically couple with the federal NCTI system based on their rolling conformity with the federal code, according to the report.
Absent changes to their conformity laws, 11 states and D.C. will tax 60% of NCTI because of the lower Section 250 deduction, according to the report. Nine other states currently tax 5% to 30% of GILTI, the report said.
Bruce Fort, senior counsel at the Multistate Tax Commission, said during a presentation at the intergovernmental agency's annual meeting in July that he expects debates about state taxation of NCTI to percolate among state lawmakers, given how different the system looks from GILTI.
Tax practitioners have argued that the states' taxation of GILTI poses constitutional concerns given the U.S. Supreme Court's 1992 decision in Kraft General Foods Inc. v. Iowa Department of Revenue. In that case, the high court ruled that Iowa had discriminated against companies' foreign subsidiaries by declining to give their dividends the same deduction granted to domestic subsidiaries.
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