Utah Rules That Taxpayer May Exclude Foreign Income from Combined Water’s Edge Return

The state income tax impact of a federal income tax election may be unclear and give rise to unintended negative state income tax consequences, as was the case in this Utah decision addressing the exclusion of certain consolidated members from the state’s combined return.

By Jeff Glickman, SALT Partner

The Internal Revenue Code (“IRC”) is littered with provisions that provide taxpayers with the ability to make elections, such as entity classification, S-Corporation, 338(h)(10),[1] and 83(b),[2] just to name a few.  In some cases, the effect of such election for state income tax purposes may not be clear, as was the situation addressed in a recent Utah Initial Hearing Order, in which an Administrative Law Judge (“ALJ”) ruled that the taxpayer may exclude foreign income from its water’s edge combined report.[3]

The taxpayer files as part of a federal consolidated group which includes two wholly owned subsidiaries formed and operating in foreign countries (i.e., neither of the foreign subsidiaries operate in Utah or the US).  These foreign subsidiaries were included in the federal consolidated group pursuant to an election made by the parent corporation under IRC § 1504(d), which allows a parent corporation to elect to treat certain foreign subsidiaries as domestic corporations.  As such, the income of the two foreign subsidiaries was included in federal taxable income (i.e., Line 28) of the consolidated group.

The taxpayer and other members of the consolidated group conduct business in Utah, and therefore, were filing as a combined group.  In Utah, the default method for filing a combined report is water’s edge, unless an election is made to file a worldwide report, which was not the case here.[4]  In Utah, a water’s edge combined report typically includes the income and factors of unitary corporate members (i) that are organized or incorporated in the US or (ii) that are organized or incorporated outside the United States but that conduct at least 20 percent of their activity in the United States as measured by the state’s apportionment factors.[5]

Based on the fact that the foreign subsidiaries didn’t conduct any business in the US and thus did not meet the requisite 20 percent US activity threshold, the taxpayer excluded them from the Utah water’s edge combined report.  Upon audit, the state included the foreign subsidiaries in the return.

The state did not dispute that the US activity threshold was not met.  It argued, however, that the taxpayer made the 1504(d) election to treat the foreign subsidiaries as domestic corporations, and therefore, they should be treated as domestic corporations for Utah income tax purposes.  In addition, the state noted that the calculation of income for Utah purposes starts with federal taxable income, which in this case included the income of the foreign subsidiaries, and that there is not statutory modification to exclude that income from the tax base.

The ALJ ultimately ruled in favor of the taxpayer, explaining that since the Utah Code is silent regarding the state’s treatment of the 1504(d) election, there is some conflict with the code provision that calculates Utah income by starting with federal taxable income when a 1504(d) election is in place for federal income tax purposes and the code provision that excludes foreign subsidiaries from a water’s edge combined return when the US activity threshold is not met.

In resolving this conflict, the ALJ relied on two principles of statutory construction.  First, tax imposition statutes are strictly construed in favor of the taxpayer, and second, a more specific statute governs instead of a more general statute.  Based on these provisions, the ALJ decided that the taxpayer was not required to include the foreign subsidiaries in its water’s edge combined report.

While the % was successful in this situation, the case highlights the fact that when a taxpayer makes an election for federal income tax purposes, it is important to review and understand the potential impact of such election for state income tax purposes to ensure that such an election makes sense from a combined federal/state perspective.

Aprio’s SALT team understands the complicated issues that may arise related to the interplay between federal and state income tax provisions.  We can help you understand and plan for any potential unintended negative state income tax consequence arising from elections (or other decisions) made for federal income tax purposes.    We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the October 2019 SALT Newsletter.

[1] An election made by a buyer and seller to certain stock sales as an asset sale.

[2] An election made by certain recipients of restricted stock to pay income tax in the year of receipt instead of the year in which the stock vests.

[3] Taxpayer v. Auditing Division of the Utah State Tax Commission, Appeal No. 18-56 (June 25, 2019).

[4] Utah Code § 59-7-402.

[5] In this case, the apportionment factors would be used to measure U.S. activity, not just Utah activity.  Utah Code §§ 59-7-101(36); 59-7-401; 59-7-402.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.