Valley Views
New federal tax change will make region less competitive
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In most respects, Idaho and Montana have been enthusiastic in their pursuit of tax competitiveness. But if there’s one area of tax policy on which they are worse than their peers, it’s in their incorporation of GILTI—the federal tax on Global Intangible Low-Taxed Income—into their own state tax codes. Not even California or Illinois does that.
Twenty states and the District of Columbia tax GILTI, and Idaho and Montana are among them. With the federal tax on GILTI undergoing substantial changes under the recently enacted One Big Beautiful Bill (OBBB), there’s no time like the present for lawmakers to reconsider this uncompetitive, and increasingly irrational, state tax policy.
Under the new federal law, GILTI is about to change to a tax on what is being called Net CFC Tested Income (NCTI). Since neither of these tongue-twisting terms is a household name, let’s take a step back to see what they are, and why these seemingly obscure provisions matter.
Prior to the enactment of the Tax Cuts and Jobs Act (TCJA) in 2017, federal corporate income taxes applied to the entire worldwide net income (profits) of a corporation, with credits for foreign taxes paid. Now the U.S. operates under a mostly territorial system, with a few guardrails to curb international tax avoidance techniques like profit shifting and the parking of intellectual property in low-tax countries. One of these guardrails is GILTI, imposed on so-called “supernormal returns.”
Essentially, under the GILTI regime, the federal government looks at the profits of foreign companies owned (or invested in) by U.S.-based multinationals, and if their annual profits are more than 10 percent of the value of their tangible property abroad, the U.S. assumes that the foreign entity is earning income from intellectual property (royalty payments on patents, trademarks, copyrights, and the like). It then taxes the foreign income above that threshold, albeit at a reduced rate, with credits for 80 percent of the value of taxes paid abroad.
The upshot of this somewhat confusing system: if you have unusually high rates of profit in your foreign subsidiaries, and you aren’t paying much in foreign taxes on that income, the U.S. slaps a minimum tax on the activity. That makes a certain amount of sense. But when some states got in the act, taxing shares of this international activity, things got messy—fast.
Now they’re getting messier.
The OBBB overhauled the federal GILTI regime and rechristened it NCTI. Now, instead of only taxing foreign profits in excess of 10 percent, all foreign income from these controlled foreign corporations is brought into the tax base. As an offset, the share of foreign tax credits that can be used against liability increases from 80 to 90 percent.
Meanwhile, a 50 percent deduction that essentially limited the resulting tax to half the ordinary rate (10.5 percent rather than 21 percent at the federal level) is trimmed to a 40 percent deduction, raising the effective rate of the minimum tax. States often provide their own deductions that interact with this: Montana taxes 20 percent of GILTI and Idaho taxes 15 percent. Each of these inclusions would rise with the reduction in the federal deduction under NCTI.
Under the GILTI regime, moreover, many expenses by U.S.-based multinationals were sourced to their foreign corporations to the extent that they were deemed to benefit them. Since these business expenses would have ordinarily been deductions from the U.S. company’s taxable income, these expense allocation rules (1) increased domestic tax liability for U.S.-based multinationals, since they were denied deductions for some of their business expenses; but, at the same time, (2) provided deductions for the foreign companies, reducing their taxable income potentially subject to GILTI. Under NCTI, these expenses are generally attributable to the parent corporation, and thus no longer reduce GILTI liability. (For a more detailed explanation of the changes go to: https://taxfoundation.org/blog/big-beautiful-bill-gilti-ncti-state-implications.)
Under this new system, the initial base is broader (all income of these foreign corporations, with fewer expense deductions) and the rates are higher. And the vital offset—a credit for foreign taxes paid—isn’t available at the state level. That’s a huge problem, because without it, the whole system falls apart.
When states tax NCTI, they’re not taxing foreign profit-shifting activity, or foreign income on which relatively little foreign tax has been paid. They’re taxing all the income of any foreign company in which a U.S.-based business has an ownership stake, even if the income was genuinely earned abroad (e.g., revenue from sales into European countries by a Europe-based corporation, rather than royalty payments for the U.S. parent company’s intellectual property sourced to a low-tax country), and without any reference to how much tax was paid to foreign countries.
Actually, it’s worse than that. Foreign taxes do matter for state tax liability, but not in the way you would expect, and not in the way Congress intended. When the federal government allows credits against the U.S.-based company’s tax liability based on taxes its foreign subsidiaries paid abroad, this involves an imputation: the taxes are included in the parent company’s income and then credited against its tax liability.
Imagine, for instance, that the U.S. company’s net income from foreign corporations was $100 million, and that those companies paid $10 million in foreign taxes. Without any tax credits, the NCTI tax liability would be $12.6 million ($100 million x 12.6 percent, which is 60 percent of the 21 percent federal rate). With the credits, however, the income is grossed up to $110 million, making pre-credit liability $13.86 million ($110 million x 12.6 percent), but then 90 percent of the value of the $10 million in foreign taxes paid is applied against the resulting tax liability, yielding $4.86 million in U.S. federal taxes.
From this, it should be obvious that it’s no trifle that states omit the foreign tax credits, given their significance. And it gets worse still: states include the gross-up of income based on foreign taxes paid, even though they don’t acknowledge the tax credits. They literally tax the amount paid in foreign taxes. In the above example, states’ NCTI tax base would be 285 percent of the federal one.
None of this makes any sense. It’s an inversion of the federal system and its purpose, and beyond that, there’s no principled way to apportion this foreign activity to specific states. Yet many states tax GILTI and are on track to even more nonsensically incorporate NCTI.
GILTI was the rare tax issue where red states were just as guilty as blue states. But the conversion of NCTI, which will flow through to states currently taxing GILTI, might just be the nudge states like Montana and Idaho and others in the Mountain West need to remove this provision from their tax codes.
There are valid reasons for the federal government to tax some of the income of U.S.-owned foreign corporations. But virtually nothing of its federal purpose, or even its intended federal base, is retained when incorporated into state tax codes, and there’s little innate justification for state taxation of international activity.
California doesn’t tax GILTI/NCTI. Illinois doesn’t either. New York, New Jersey, and Massachusetts eliminated all but a small share (5 percent inclusion). It’s time for policymakers in the Mountain West to ask why their states tax it, especially now that an already uncompetitive element of their state tax code is about to become considerably more burdensome.
Jared Walczak is Vice President of State Projects at the Tax Foundation.
