Companies in Limbo as States Adjust Taxes to Federal Overhaul

By EZEQUIAL MINAYA, Wall Street Journal

Businesses across the U.S. are paying more attention to state taxes, which have become a larger share of their total tax liability. While the federal corporate tax rate fell to 21% from 35% under last year’s federal tax overhaul, state tax rates remained unchanged. Many states are expected to lower their corporate tax rates, in line with the federal reduction, as a way to project a business-friendly environment.

But it isn’t always easy. Minnesota state lawmakers and their governor ended a legislative session last month in a stalemate, unable to agree on a bill that updates the state tax code to reflect the federal overhaul.

Among the sticking points: How to apply a new federal provision that levies a one-time tax to corporate profits stored overseas? Companies based in the state, including General MillsInc., GIS +3.64% Ecolab Inc. ECL -0.26% and 3M Co. MMM -0.39% , are caught in the middle, with hundreds of millions of dollars on the line.

“It does add confusion, it does add complexity when you don’t have reconciliation between the state code and federal code,” said David MacLennan, chief executive of Minneapolis-based agricultural conglomerate Cargill Inc. “It’s very discouraging to read and hear the political rhetoric.”

The tax debate that gripped Washington last year is rippling across 50 state capitals and could extend in some statehouses beyond this year. The federal legislation, signed shortly before Christmas, caught many state legislatures flat-footed. Previously, big federal tax changes involved months of debate and review.

“A tax bill rolling through a legislature is live ammunition,” because of the politics at play, said John Hicks, executive director of the National Association of State Budget Officers.

On average, about 5% of state revenue comes from corporate taxes, Mr. Hicks said. The latest U.S. Census data indicates companies contributed a total of $57 billion in general revenue to states in 2015.

Conforming to changes in the federal tax code is typically a routine process for states, which use federal tax rules as a basis for local norms. More than 40 states take their figure for corporate taxable income straight from a line off the federal return, either before or after net operating losses are applied. But the scope of the changes this year is far beyond the norm.

The broadening of the tax base by the federal legislation will allow states to tax more of a company’s revenue,, according to a business-backed study from Ernst & Young LLP. The study estimates that the state corporate tax base will grow by 12% on average.

How states sync up with federal deductions and credits varies because, among other reasons, states generally have balanced-budget requirements, unlike the federal government, as well as set their own tax rates.

Max Behlke, director of budget and tax policy for the National Conference of State Legislatures said confusion was widespread. “We were getting calls from states asking how is this going to impact us and understanding that is a state-by-state endeavor.”

Some states have already acted. In March, Georgia cut its corporate income tax rate to 5.75% from 6%. Missouri is considering slashing its corporate rate to 4% from 6.25%.

Some provisions of the federal tax bill that have received the greatest scrutiny have included expensing provisions, net operating loss-deduction limitation, the revised treatment of contributions to capital, business interest-deduction limitation and federal changes to the treatment of foreign profits.

In Tennessee, the legislature has already rejected a federal provision that limits interest deductibility. The move by lawmakers is expected to save businesses in Tennessee $1.2 billion over the next 10 years.

“If we didn’t decouple from the provision, we think it would have had a negative impact on business growth and development,” said Tennessee State Sen. Bo Watson, a Republican and chairman of the state’s Senate Finance, Ways and Means Committee.

A smaller group of states, however, appears to be considering using the federal tax changes to capture more state revenue.

In California, one state assemblyman proposed a 10% surcharge on top of the existing state corporate tax rate to capture some of the savings companies expected following the reduction of the federal tax rate. Democratic Gov. Jerry Brown’s latest budget revisions in May raised projected corporation tax revenue up 8.9% to $11.02 billion, in part because of new federal tax rules on repatriation of foreign earnings.

“It’s clear that our state taxes have been affected in a way that is going to result in a fairly large increase in tax,” said Jay Rembolt, chief financial officer of San Diego-based WD-40 Co. “The challenge we had early on was that we would have a question and then get two answers that were diametrically opposed.”

Mr. Rembolt, hesitated earlier this year in deciding how much foreign profit to bring home while seeking more clarity on tax policy in the various states in which WD-40 files returns.

“We’re slowly working through the list of questions,” he said.  “I don’t think that ramifications on the state level were part of [federal lawmakers’] consideration,” he added.

Company executives and representatives of accounting firms say they expect some unpredictability when it comes to effective tax rates. Business leaders will have to increasingly depend on manual processes and custom algorithms and software to model the state tax rate impact of tax overhaul, said Ann Holley, a partner in the state and local tax group of KPMG’s Washington National Tax practice.

“Anything new of this magnitude you are going to have controversy come out of it,” Ms. Holley said. “Applying the new law is not always going to be clean.”