Tax Credit Transfers May Have Unexpected State Tax Consequences

State Income Tax, Tax Conformity, and Exceptions

44 states and Washington, D.C. impose state income taxes on corporate entities. An additional four states impose taxes on gross receipts rather than income. All states with income taxes, and three of the four states with gross receipts taxes, incorporate at least some provisions of the federal IRC, and any applicable regulations in force, to provide the methodology for calculating certain deductions, income, receipts, and other items. How and the extent to which a state follows the IRC is known as “conformity.”

Broadly speaking, there are two types of conformity.

The first, and generally the simplest, is known as “rolling” conformity: state law simply incorporates federal tax law in effect for the current tax year. Changes to federal tax law (via statute or regulation) automatically change state tax law. There is a separate concept, called “decoupling,” where states may largely conform to federal law but carve out specific sections, and taxpayers concerned with energy credits will need to confirm that the relevant states have not decoupled from federal law in relevant ways. But in general, in a rolling conformity state, state income tax calculations are performed the same way federal calculations are under current law. 24 states are “true” conformity states, with another three using rolling conformity for corporate income tax but not necessarily for non-corporate income tax. In these states, absent some sort of decoupling, state tax treatment tracks federal tax treatment in any given year and there is little concern.

Three states, Arkansas, Mississippi, and Nevada (with respect to Nevada’s gross receipts tax), conform to provisions of the IRC, but are known as “specific conformity” states, meaning they incorporate provisions of federal tax law specifically, rather than the entire federal tax code.

Eighteen states, however, have what is called “fixed” conformity. Their statutes conform to federal tax statutes and regulations as of a specific date; incorporation of subsequent federal tax changes requires a legislative act, either by changing the conformity date or by identifying specific changed provisions. These states create a significant trap for the unwary, which is discussed below.

The Fixed Conformity Trap

In general, in fixed conformity states, state income (or gross receipts, in the case of Texas and Ohio) calculations work the way they would work under federal tax law – but only true as of the conformity date.

Prior to the enactment of the IRA, the ITC and PTC existed, but the credits could not be bought or sold. So, neither federal tax law nor federal tax regulations had any need to address the tax consequences of those sales. When the IRA was enacted on August 16, 2022, Congress correctly anticipated that these issues would need to be addressed, and § 6418 was included in the law, specifically stating that the sale of tax credits did not result in gross income, and that the IRS was empowered to issue regulations or guidance to carry out the purposes of that section. Under this authority, the IRS subsequently issued guidance indicating that the purchase and use of credits does not result in any taxable gain (which is the opposite of the IRS’s treatment of many transferable state tax credits, which can result in taxable gain). In any rolling conformity state that has not decoupled from federal law, state tax treatment simply follows federal treatment.

But in fixed conformity states, this is not so. If a state’s conformity date is before August 16, 2022, then, absent other legislative enactments or guidance, IRC § 6418 does not exist for purposes of state law, and if the conformity date is prior to April 2024, then the state does not conform to the final regulations governing the tax treatment to buyers. Instead, tax law as it existed prior to those dates controls.

For tax credit sellers, this creates a particular problem. The general rule, set forth in IRC § 64, is that unless something is specifically excluded from income, it is considered to be taxable income. So, generally, the sale proceeds aren’t ignored for federal tax purposes – they are, presumably, included in income. Conversely, the rule that buyers cannot deduct the price they pay for the credits is not in effect in these states.

Ambiguities in Fixed Conformity States – Texas and California

At least, that’s the assumption. But when a taxpayer has income relating to an item (sale of federal tax credits) that simply did not exist as of the conformity date, it’s unclear what the correct tax treatment should be. Texas and California are two of the states with the most renewable energy development; both are fixed conformity states and suffer from this kind of ambiguity.

California highlights a problem that may be present in many fixed conformity states. It conforms to the Internal Revenue Code as of January 1, 2015, such that tax credit sale proceeds are taxable income; that much is simple. A separate question, beyond the scope of this piece, is whether and to what extent those proceeds are apportioned to California or another state; the answer depends on various factors, including the buyer’s location, but in some cases the proceeds will be apportioned to California. There is presently legislation pending to conform California law to federal law as to this specific issue, but it is not yet law. The implications of the above lead to some interesting conclusions, however.

In general, where the ITC (but not the PTC) is claimed, the taxpayer is required to adjust its basis in the property pursuant to IRC § 50(c), reducing that basis by 50% of the tax credit amount; this reduces depreciation deductions, effectively preventing a certain amount of double dipping on tax benefits. This means the taxpayer effectively loses some level of depreciation deduction in exchange for getting the tax credit; financially, this is a worthwhile trade. But importantly, § 50(c) dates back decades, well before California’s conformity date. So it would seem that in California, for state income tax purposes, a seller of tax credits: a) no longer can use the tax credits itself, because it has sold them; b) has to recognize income on the proceeds of the sale, and c) still appears to have to reduce its basis in the property, lowering its state tax deductions. Some practitioners argue that this result is wrong because California has effectively decoupled from current tax law; but nothing in California law as of this writing appears to definitively conclude that taxpayers are allowed to ignore § 50(c) when they sell energy credits. 

Texas presents an even more concerning ambiguity. Texas is one of the states without a corporate income tax; instead, it has a gross receipts tax, known as the “franchise tax.” For Texas franchise tax purposes, a term called “taxable margin” is calculated based on total gross receipts. The specific calculation is in Texas Tax Code § 171.1011(c), which makes reference to several lines of “Internal Revenue Service Form” 1120 or 1065 (corporation or partnership returns, as appropriate). And § 171.1011(b) provides that “a reference to an amount reportable as income on a line number on an Internal Revenue Service form is the amount entered to the extent the amount entered complies with federal income tax law.” 

Texas’s conformity to federal income tax law is via Texas Tax Code § 171.0001(9), which defines “Internal Revenue Code” as the code as of January 1, 2007 as well as regulations in effect as of that date. Presumably, the legislative intent is that in calculating gross receipts for taxable margin purposes, you’d look to federal tax law as of January 1, 2007, when there was nothing excluding tax credit sale proceeds from income.

Except, if one looks back at Texas Tax Code §§ 171.1011(b) and (c), for purposes of what you include in gross receipts, they do not use the term “Internal Revenue Code” at all. They talk about forms. And in turn, the statute’s rule regarding forms does not reference “Internal Revenue Code,” it references “federal income tax law.” A completely fair reading of the statute is that the references to the forms must comply with federal income tax law as it exists during the period for which the tax form applies; not to the 2007 date. Reading “federal income tax law” to have the same meaning as “Internal Revenue Code,” would not give effect to the legislative choice between these two terms, and under the rules of statutory construction applied by Texas courts, they should not be given the same meaning. But it seems unlikely the Texas Comptroller of Public Accounts would read this section as excluding tax credit sale proceeds from Texas gross receipts. So, taxpayers are faced with a choice to either pay what might very well be extra tax under the plain language of the statute, or else risk a lengthy and expensive Texas franchise tax audit, including possible tax penalties. This is the kind of ambiguity a legislature could clear up, but nothing has suggested that a legislative fix is imminent.

Conclusion

The above examples are just two of the potential traps that exist in states with fixed conformity. The federal statute and regulations are designed to work cohesively around this new source of revenue for renewable energy generators, but in fixed conformity states, there are legislative gaps that do not necessarily have good answers, or that seem to yield results that are outside of legislative intent.

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