Introduction
One frequent question that arises is the extent to which U.S. income tax treaties can apply to reduce state income tax. The prevailing opinion is that income tax treaties are limited to “federal income taxes imposed by the Internal Revenue Code” as stated in the treaty, but that opinion is incorrect.
States that Defer to Section 61
Most states (but not all) defer to Internal Revenue Code section (herein “Section”) 61 for the definition of “gross income.”[1] Section 61 states “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived.” The key phrase here is “[e]xcept as otherwise provided in this subtitle.” This phrase means that other provisions in Title 26, Subtitle A, of the U.S. Code modify Section 61. One such provision under Subtitle A is Section 894.
Section 894(a)(1) mandates that all “provisions of [the Internal Revenue Code] shall be applied to any taxpayer with due regard to any treaty obligation of the United States which applies to such taxpayer.” In other words, Section 61 is statutorily modified and to be applied consistent with any treaty obligation that applies to a taxpayer.[2] By operation of Section 894(a)(1), Section 61 is modified to the extent there is an applicable income tax treaty. Therefore, if the state defers to Section 61 for the definition of gross income, which is modified by any applicable income tax treaty in accordance with Section 894(a)(1), then it logically follows that any income excluded from an individual U.S. federal income tax return pursuant to an applicable income tax treaty is excludible on said individual’s state individual income tax return.
States that Do Not Defer to Section 61
Where federal and state statutes and regulations are substantially identical, the interpretation and effect given to the statute by federal courts is highly persuasive. [3] That being said, even in states where state tax law does not expressly defer to Section 61 yet defines gross income in a substantially identical manner, there is legal authority for the proposition that income tax treaties apply.
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Bluebook Citation: Income Tax Treaties Apply to State Income Tax, Int’l Tax Online Law Journal (Feb. 7, 2020) url.
[1] See, e.g., Cal. Rev. & Tax. Code § 17071; Mass. Gen. Laws ch. 62, § 1; D.C. Code § 47-1803.02(a).
[2] See Nat’l Grid Holdings, Inc., C292287 (June 4, 2014) (Massachusetts Appellate Tax Board recognized the application of the U.S.-U.K. Income Tax Treaty to a corporate taxpayer resident in Massachusetts).
[3] Where federal and state statutes and regulations are substantially identical, the interpretation and effect given to the, by federal courts are highly persuasive. See Rihn v. Franchise Tax Bd., 131 Cal. App. 2d 356, 280 P.2d 893 (1955). Because California tax law defers to federal law for the definition of gross income, it is appropriate for state courts to look to federal law as well as state law. In re Shelley, 184 B.R. 356 (B.A.P. 9th Cir. 1995), aff’d, 109 F.3d 639 (9th Cir. 1997); also see D.C. v. ACF Indus., Inc., 350 F.2d 795 (D.C. Cir. 1965). Because California income tax law is largely based on federal income tax law, any increase or decrease in an individual’s federal tax liability will generally have a corresponding increase or decrease in state tax liability. See Goldman v. California Franchise Tax Bd., 202 Cal. App. 4th 1193, 136 Cal. Rptr. 3d 373 (2012); See Sch. St. Assocs. Ltd. P'ship v. D.C., 764 A.2d 798 (D.C. 2001).