Earlier this week, the US Department of the Treasury (Treasury) issued formal guidance regarding the administration of the American Rescue Plan Act of 2021 (ARPA) claw-back provision. The guidance (Interim Final Rule) provides that the claw-back provision is triggered when there is a reduction in net tax revenue caused by changes in law, regulation or interpretation, and the state cannot identify sufficient funds from sources other than federal relief funds to offset the reduction in net tax revenue. The Interim Final Rule recognizes three sources of funds that may offset a net tax revenue reduction other than federal relief funds—organic growth, increases in revenue (e.g., a tax rate increase) and certain spending cuts (i.e., cuts that are not in an area where the recipient government has spent federal relief funds). According to the Treasury, this framework recognizes that money is fungible and “prevents efforts to use Fiscal Recovery Funds to indirectly offset reductions in net tax revenue.”
The Interim Final Rule also provides guidance on what is considered a change in law, regulation or interpretation that could trigger the claw-back (called covered changes), but that point remains somewhat ambiguous. The Rule provides that:
The offset provision is triggered by a reduction in net tax revenue resulting from ‘a change in law, regulation, or administrative interpretation.’ A covered change includes any final legislative or regulatory action, a new or changed administrative interpretation, and the phase-in or taking effect of any statute or rule where the phase-in or taking effect was not prescribed prior to the start of the covered period. [The covered period is March 3, 2021 through December 31, 2024.] Changed administrative interpretations would not include corrections to replace prior inaccurate interpretations; such corrections would instead be treated as changes implementing legislation enacted or regulations issued prior to the covered period; the operative change in those circumstances is the underlying legislation or regulation that occurred prior to the covered period. Moreover, only the changes within the control of the State or territory are considered covered changes. Covered changes do not include a change in rate that is triggered automatically and based on statutory or regulatory criteria in effect prior to the covered period. For example, a state law that sets its earned income tax credit (EITC) at a fixed percentage of the Federal EITC will see its EITC payments automatically increase—and thus its tax revenue reduced—because of the Federal government’s expansion of the EITC in the ARPA. This would not be considered a covered change. In addition, the offset provision applies only to actions for which the change in policy occurs during the covered period; it excludes regulations or other actions that implement a change or law substantively enacted prior to March 3, 2021. Finally, Treasury has determined and previously announced that income tax changes—even those made during the covered period—that simply conform with recent changes in Federal law (including those to conform to recent changes in Federal taxation of unemployment insurance benefits and taxation of loan forgiveness under the Paycheck Protection Program) are permissible under the offset provision.
This leaves some questions unanswered: Does a rate increase adopted during the covered period—that also sunsets during the covered period—trigger the claw-back? Do changes that decouple from federal provisions of the Internal Revenue Code (IRC) trigger the claw-back? (The answer should be and, seemingly is, “no” based on past statements from the Treasury) Is case law or legislation striking a tax or law as unconstitutional or invalid as being inconsistent with another law “a change within the control of the state or territory”? (The answer should be “no.”)
Once the covered changes are identified, the Interim Final Rule provides a four-step process for determining whether a reduction in net tax revenue (1) is attributable to a covered change and (2) has been directly or indirectly offset with federal relief funds. Below are the steps provided by the Treasury:
- First, each year, each recipient government will identify and value the covered changes in law, regulation or interpretation that would result in a net tax revenue reduction as it would in the ordinary course of its budgeting process. The sum of these values in the year for which the government is reporting is the amount it needs to “pay for” with sources other than Fiscal Recovery Funds (total value of revenue reducing changes).
- Second, the Interim Final Rule recognizes that it may be difficult to predict how a change would affect net tax revenue in future years and, accordingly, provides that if the total value of the changes in the year for which the recipient government is reporting is below a de minimis level [1% of the reporting year’s revenue], the recipient government need not identify any sources of funding to pay for revenue reducing changes and will not be subject to recoupment.
- Third, a recipient government will consider the amount of actual tax revenue recorded in the year for which they are reporting. If the recipient government’s actual tax revenue is greater than the amount of tax revenue received by the recipient for Fiscal Year (FY) 2019, adjusted annually for inflation, the recipient government will not be considered as having violated the offset provision because there will not have been a reduction in net tax revenue.
- Fourth, if the recipient government’s actual tax revenue is less than the amount of tax revenue received by the recipient government for FY 2019, adjusted annually for inflation, in the reporting year the recipient government will identify any funds sources that have been used to permissibly offset the total value of covered tax changes other than Fiscal Recovery Funds. These are: State or territory tax changes that would increase any source of general fund revenue, such as a change that would increase a tax rate; and spending cuts in areas not being replaced by Fiscal Recovery Funds. The recipient government will calculate the value of revenue reduction remaining after applying these sources of offsetting funding to the total value of revenue reducing changes—that is, how much of the tax change has not been paid for. The recipient government will then compare that value to the difference between the baseline and actual tax revenue. A recipient government will not be required to repay an amount that is greater than the recipient government’s actual tax revenue shortfall relative to the baseline to the Treasury (i.e., FY 2019 tax revenue adjusted for inflation). This “revenue reduction cap,” together with Step 3, ensures that recipient governments can use organic revenue growth to offset the cost of revenue reductions.
This framework, specifically the revenue reduction cap in Step 4 and the use of FY 2019 as the baseline, is advantageous to states that saw population growth last year (Florida, Texas, Tennessee, etc.). The guidance is overall useful in understanding exactly how the Treasury will compute the amount of the claw-back. However, as mentioned above, there are still some uncertainties regarding what is and what is not a covered change that triggers the claw-back. That said, we expect reasonable legislatures, and likely even the Treasury itself, to interpret the definition of “covered change” narrowly to allow for actions like decoupling from federal IRC provisions and striking unconstitutional and invalid laws. While not entirely clear, the Interim Federal Rule does support a narrow interpretation.