Maryland Shouldn’t Mandate Worldwide Combined Reporting Through the Backdoor

Maryland’s proposed budget (House Bills 350 and 352) has garnered headlines for many reasons—state and local income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. increases, a high earners’ capital gains surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. , and a new 3 percent tax on some business-to-business data and information services among them—but another momentous change is flying under the radar: backdoor adoption of potentially mandatory worldwide combined reporting.

While the legislation purports to provide an election that would make worldwide combined reporting voluntary, it would give the Comptroller carte blanche authority to restrict that election by regulation or to deny it to any company for any (or no) reason.

Currently, Maryland uses what is called the separate accounting method for determining corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. liability, meaning that each company is taxed separately based on a Maryland-apportioned share of its profits, with apportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders. based on in-state sales. If a company (based anywhere, not just Maryland) earns $100 million in profits and 10 percent of its sales are into Maryland, then Maryland would tax $10 million worth of that company’s profits. The other common model is called combined reporting, where related companies (parent companies, subsidiaries, affiliates, etc.) are treated as a single entity for tax purposes, with all their profits and losses combined, after which combined profits are apportioned for tax purposes.

Each state with a corporate income tax apportions corporate activity to the state for tax purposes based on some combination of the share of sales, payroll, and property in the state. This approach to divvying up taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. is called formulary apportionment. Increasingly, many states, including Maryland, rely exclusively on sales (known as “single sales factor”).

Imagine a company with two subsidiaries, one operating entirely in Maryland, and the other doing business only in Wisconsin. They have the same volume of sales and the same level of profitability. Wisconsin, with combined reporting, would tax half the profits of both subsidiaries, while Maryland, currently with separate accounting, would tax all the profits of the Maryland entity but none of the profits of the other company in the unitary group.

In our example, these two different approaches yield the same amount of taxable income. But if the Wisconsin entity were more profitable than the Maryland one, then Wisconsin would lose out by having combined reporting (since these profits are averaged with the less profitable Maryland affiliate), whereas Maryland would generate more revenue if it adopted combined reporting—and vice versa if the Maryland entity were the more profitable company.

Combined reporting can introduce complexity, as there are often disagreements about which affiliated entities are properly considered part of the unitary group for tax purposes. It can also lead to taxing the wrong income in the wrong place at the wrong rate, when one or more of the businesses brought into the unitary group do little or no business in the state that is aggregating them for tax purposes. Often, just because businesses have the same corporate parent doesn’t mean that their operations are combined in any meaningful way.

Proponents of combined reporting, however, see it as a way to combat tax avoidance, where a business might try to shift its profits to a subsidiary located in a low-tax state by having some related companies make royalty or other payments to a company with better tax treatment. Combined reporting would include that subsidiary in the unitary group and thus negate the attempted tax avoidance.

A shortcoming of combined reporting is that it aggregates the profits (and losses!) of affiliated companies operating elsewhere whether their income is tax-motivated or not. It can’t, and doesn’t try to, distinguish between the two. That’s why some states have instead adopted addback statutes which deny deductions for certain intercompany transactions, like royalty and interest payments made to a subsidiary. Maryland adopted just such an addback regime in 2018, at the same time it adopted its current (sales-only) apportionment factors.

Under the budget bill under consideration, Maryland would—despite the existing addback—adopt combined reporting. More than that, it would not just bring in US companies, as is standard under combined reporting regimes, but would adopt worldwide combined reporting. And most notably, it would become the only state in the nation where businesses might be forced into worldwide combined reporting.

Eleven states and D.C. have worldwide combined reporting as an election, either with waters’ edge (meaning US activity only) as a default from which a business can opt out or, as in states like California, with worldwide combined reporting as a default but with an election for waters’ edge reporting. With the exception of Alaska’s treatment of oil and gas companies, however, no state mandates worldwide combined reporting.

This is important because, whereas all US states use formulary apportionment (usually share of sales, as in Maryland), the rest of the world uses a different system with separate accounting and no apportionment.

Instead, other countries tax companies based within their borders, and activity taking place within their boundaries, and extend credits for taxes paid to other countries. In this way, tax treatment is much like how state individual income taxes (but not corporate income taxes) work in the United States. Adopting worldwide combined reporting is a mix-and-match approach, apportioning income that is also being taxed under a different regime elsewhere, without offering credits for taxes paid to other jurisdictions.

The US apportionment system has its own problems with double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. , but by mixing two radically different ways of determining the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. associated with a particular country or state, worldwide combined reporting elevates double taxation to an art form.

When states force companies to apportion some of the profits of their foreign subsidiaries, they also massively increase compliance costs for many businesses, since those subsidiaries’ books must be converted from local rules to align US and state accounting rules, and transactions recorded in different currencies must be standardized. Factors that do not matter for taxation elsewhere—like the payroll of all affiliates in all countries, even for subsidiaries that do no business in the United States—must be tracked to comply with a single state’s apportionment regime.

A bill was introduced in Maryland this year that would adopt mandatory worldwide combined reporting. That does not seem likely to advance. But the budget does something similar in a backdoor way. It adopts worldwide combined reporting as the default, then allows companies to elect waters’ edge treatment, but then—crucially—permits the Comptroller’s office to strip that election away from businesses.

First, the Comptroller can adopt regulations restricting the ability to make the election, with no limiting principle on how restrictive those regulations can be; and second, the Comptroller can unilaterally deny any given company’s election without even needing to state a reason. This is not truly a waters’ edge election at all—or at least, it’s one that only exists at the Comptroller’s pleasure.

Whether companies would be subject to this double taxing regime would be left up to whatever regulations the Comptroller decides upon, completely beyond the legislature’s purview. The Comptroller’s office could even decide to deny the election to specific companies, without needing any reason for the denial. That sort of arbitrariness and unpredictability has no place in a tax code.

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