Easing the Kentucky Combined Reporting Transition

March 19, 2019

Last year, Kentucky adopted a major tax overhaul: it dropped its income and corporate taxes by a point, removed numerous credits and carveouts from the income and sales taxes, reduced the archaic inventory tax, and adopted single-sales factor apportionment and combined reporting for business taxes. Altogether, the package (enacted over Governor Bevin’s veto) raised some $395 million in annual revenue, to address the state’s crushing public employee pension shortfall.

Combined reporting, effective in Kentucky as of January 1, 2019, requires all corporations within one business group file a consolidated return for their activities in the state. It is distinct from separate reporting, a filing method where each subsidiary files its taxes as a distinct entity. Proponents of combined reporting say without it, multistate corporations will artificially move income between subsidiaries in different states to reduce tax liability. Opponents say defining the unitary group and calculating income is more complex than it’s worth, that subsidiaries exist for legitimate business reasons and punishing every company for a few bad actors harms the economy as a whole, and that combined reporting results in arbitrary assignment of income to different states (the thing it supposedly combats).

Counting Kentucky, 26 states and D.C. currently use combined reporting as the default filing method, and it is a hot topic in state corporate tax policy. This isn’t Kentucky’s first foray into changing business filing defaults, with the General Assembly permitting voluntary combined reporting from the 1990s until 2005, then prohibiting combined reporting from 2005 until this new law requiring it. (Confusingly, Kentucky’s Court of Appeals ruled on January 4 that this was the case even though the Department of Revenue was directing corporations to file on a combined basis at the time.) Everyone’s playing catch-up to the new default, and many in the business community want to repeal combined reporting outright or make it voluntary only.

Setting the merits of combined reporting aside, there is something Kentucky could consider to ease the one-time transition costs. A sudden switch of tax regimes benefits some companies and negatively impacts others. A third category is businesses that are not negatively harmed on an ongoing basis, but must revalue their assets as a result of either a reduced value of tax loss carryforwards or other change in assets or liabilities. Under current accounting rules, those “asset” write-downs must be taken quickly and reported on financial statements, harming a company’s valuation even if the tax change boosts profits going forward.

Other states like Connecticut, Massachusetts, and New Jersey have turned to the ASC 740 deduction as a clever fix for this problem. The state creates a narrow and limited deduction in the amount of any asset write-down as a result of the tax regime change, with only publicly traded companies that have to produce public financial statements eligible. Companies have to apply for the deduction by a given date not long after combined reporting is adopted, although the state need not pay out the deduction for years. (Connecticut in 2015 passed a law to pay out the ASC 740 deduction for seven years beginning in 2018 but later amended it to pay it out over 30 years beginning in 2021; Massachusetts was originally seven years starting in 2012 but is now 30 years starting in 2021; D.C. has put theirs off until 2020; and New Jersey until 2023.) In fact, the state can choose to keep extending when it will pay out the deduction, since what matters to the company is not the money but the deferred tax asset it can put on its books to offset the liability. The date and eligibility restrictions prevent it from being abused for unintended purposes.

Hopefully one day accounting and tax can be harmonized to the point where profitable companies aren’t punished because of the decline in value of their tax “assets” because of lower and simpler taxes. A big step was the 2017 federal tax law allowing companies to expense purchases of new equipment immediately rather than depreciating them for tax purposes over many years, removing a tax accounting rule that was disconnected from real-world cash flows, punished investment, and artificially rewarded borrowing. In the meantime, states adopting combined reporting can reduce the shock to balance sheets of that change with tools like the ASC 740 deduction.

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