Colorado regulation changes impact NOLs, FSI exclusion, and Section 78 subtraction

May 2023

In brief

The Colorado Department of Revenue on April 5 announced adoption of several rule changes (the Rule Changes) affecting: (1) Colorado’s net operating loss (NOL), (2) foreign source income (FSI), and (3) the Section 78 dividend subtraction.  

The takeaway: The Rule Changes make significant modifications to the operation and calculation of Colorado’s NOL, FSI exclusion, and Section 78. Although taxpayers should review all elements of the changes to determine their impact, a few items are of particular significance. For example, since we anticipate the Department will focus on the treatment of NOLs, taxpayers should document their carryforwards consistent with the treatment provided in Colorado’s rules, which may provide significantly different treatment than what existed prior to the Rule Changes.

The Rule Changes incorporate guidance regarding calculating the NOL SRLY limitation. Previously, the Department had not provided specific guidance and taxpayers used various methods. Additionally, the Rule Changes provide Section 382 apportionment treatment that is not found in Colorado statutes.

[Colorado Department of Revenue, Rule 39-22-504-2, Rule 39-22-303(10), Rule 39-22-304(3)(j) (4/5/23)]  

In detail

Net operating losses 

Prior to the Rule Changes, Rule 39-22-504(2) generally provided that Colorado’s NOL was computed “the same as a federal net operating loss except that the Colorado loss is computed using the modified federal income allocated and apportioned to Colorado.” 

Effective on April 5, 2023, Rule 39-22-504(2) was stricken in its entirely and replaced with the guidance described below. 

Allocation of federal NOL to Colorado 

Similar to the historical Rule, Colorado provides that a Colorado NOL “is allowed in the same manner as a federal net operating loss, except that the Colorado net operating loss is computed as only that portion of the federal net operating loss that is allocated to Colorado.” The Rule Changes provide the following new guidance: 

  • Combined, consolidated, and combined-consolidated returns. Colorado NOLs are calculated with respect to only the C corporations that are included in such return and based upon the federal NOL determined with respect to only such group of C corporations.
  • Separate returns. NOLs are calculated with respect to only that filing C corporation based upon its federal NOL.
  • Modified federal NOL. The federal NOL is modified by: 
    • Colorado addition modifications under CRS 39-22-304(2), 
    • Colorado subtraction modifications under CRS 39-22-304(3), and  
    • foreign source income exclusions under CRS 39-22-303(10).
  • Allocation and apportionment of modified federal NOLs. Taxpayers subtract nonapportionable income from the modified federal NOL (unless an election is made to treat all income as apportionable). The remaining amount is apportioned pursuant to the state’s apportionment rules.
  • Colorado NOL limitation. Generally, a taxpayer’s Colorado NOL cannot exceed its federal NOL.
  • Colorado NOLs are computed pursuant to laws in effect during the loss year.

NOL carryforwards 

Enacted on June 26, 2020, H.B. 1024 modified CRS 39-22-504(3) to provide that: (1) NOLs of corporations generated in income tax years commencing before January 1, 2021, may be carried forward for the same number of years as allowed for a federal NOL and (2) NOLs of corporations generated in income tax years commencing on or after January 1, 2021 may be carried forward for 20 years  

Pursuant to the Rule Changes, Rule 39-22-504(2) provides that: 

  • The entire amount of any Colorado NOL shall be first carried forward to the tax year immediately following the tax year in which the loss was sustained.
  • In the event a C corporation has available for deduction Colorado NOLs originating in multiple tax years, the C corporation must first deduct the loss arising from the earliest tax year. 
  • If all or any part of an available NOL may not be deducted because of limitations described below, the part that may not be deducted may be carried forward to the next tax year, but in no event may a loss be carried forward beyond the time periods prescribed in CRS 39-22-504(3). 

Limits on the Colorado NOL deduction 

Pursuant to the Rule Changes, Rule 39-22-504(3) provides generally that a Colorado NOL is subject to the same limitations imposed upon a federal NOL, including (a) IRC Section 172 (a)(2) (the 80% limitation); (b) IRC Sections 381, 382, and 384; and (c) Treas. Reg. 1.1502-21.

80% limitation 

Enacted on July 11, 2020, H.B. 1420 provides that, for losses incurred after December 31, 2017, the 80% limitation in IRC Section 172(a)(2) applies without regard to the amendments made under section 2303 of the CARES Act. Based on this change, Colorado will apply the 80% limitation and the original application of taxable income enacted prior to the CARES Act.  

Pursuant to the Rule Changes, Rule 39-22-504-2(3)(b)(ii) provides that: 

  • The 80% limitation applies to Colorado NOL deductions claimed for losses arising in tax years beginning after December 31, 2017, regardless of the tax year for which the deduction is claimed. 
  • The 80% limitation applies with respect to a C corporation’s Colorado taxable income before the NOL deduction determined under the rule. Federal taxable income is determined with regard to any deduction allowed under Section 250.
  • The 80% limitation applies with respect to Colorado taxable income after the deduction of any Colorado NOL deduction allowed under Sec. 39-22-504 for a loss arising in a tax year beginning prior to January 1, 2018. 

An April 2023 update to the Department’s CARES Act Tax Law Changes & Colorado Impact guidance provides that “the Colorado C Corporation Income Tax Return (form DR 0112) for tax years 2019 and later includes a specific line for deducting Colorado net operating losses arising in tax years beginning after December 31, 2017, that are subject to the 80 percent limitation. Therefore, although the CARES Act suspended this limit, C corporations may not amend their returns to claim additional net operating losses despite the recent” decision in Anschutz v. Department of Revenue, determining that retroactive changes in federal law can affect a taxpayer’s Colorado taxable income. Please click here for our Insight providing more detail on the revised guidance and click here for our Insight summarizing Anschutz.

SRLY and Treas. Reg. 1.1502-21 

The Rule Changes provide that Treas. Reg. 1.1502-21 is “incorporated by reference.” The Rule provides considerable guidance and examples regarding SRLY applications.

Among other provisions, the Rule Changes state that “[f]or its application to the Colorado net operating loss deduction, the net operating loss limitation prescribed by section 382 of the Internal Revenue Code shall be apportioned to Colorado using the Colorado apportionment fraction for the old loss corporation for the last full tax year prior to the change in ownership.”  

Observation: The Section 382 apportionment treatment is not set forth in Colorado statutes.

Observation: The Rule Changes provide a specific methodology for calculating the SRLY limitation. Previously, the Department had not provided guidance and taxpayers used various methods. 

Foreign source income  

The Rule Changes repeal existing Rule 39-22-303(10) and replace it with guidance regarding the definition of FSI, the calculation of the amount of FSI considered in the apportionment and allocation of a C corporation’s net income, and the requirement to report any changes to that amount.

General apportionment and allocation guidance 

Regarding a group return (combined, consolidated, or combined-consolidated), the FSI exclusion is calculated with respect to only members of such group based upon the foreign tax credit or deduction determined with respect to only such members.

Regarding a separate return, the FSI exclusion is calculated with respect to only that corporation and based upon the foreign tax credit or deduction determined with respect to only that corporation. 

Foreign source income 

FSI potentially eligible for exclusion includes: 

  • the types of income enumerated in IRC Section 862(a); 
  • income allocated to sources without the United States pursuant to IRC Section 863; 
  • Subpart F income, global intangible low-tax income (GILTI), any Section 78 gross-up, and any item of income treated as arising from sources outside of the United States under treaty obligation of the United States as described certain IRC sections. 

Foreign tax implications 

The new regulation explains the application of the FSI exclusion to corporations that have elected to claim foreign taxes paid or accrued as a federal deduction and as a credit.

The regulation notes that, for a corporation electing the credit, the FSI exclusion must be calculated separately with respect to each category for which separate calculation of the foreign tax credit is required. 

Section 303(8)(b) entities 

Enacted on June 23, 2021, H.B. 1311, for tax years beginning or after January 1, 2022, C.R.S. Sec. 39-22-303(8)(b) provides that corporate taxpayers must include in their combined filing group any affiliated group member incorporated in a foreign jurisdiction for the purpose of tax avoidance (a “Section 303(8)(b) Entity”) 

The Rule Changes provide FSI guidance regarding entities that are included in a group return as a Section 303(8)(b) Entity. 

Section 78 

The Rule Change provides that "foreign source income” excludes amounts treated as a dividend received by the corporation with respect to IRC Section 78.

Other provisions 

As noted by the legislature’s “Basis and Purpose” document, the Rule Changes also provide that:  

  • foreign taxes considered in the calculation of the FSI exclusion are subject to IRC Section 904 limits;  
  • the effective federal corporate income tax rate is determined without regard to credits allowed or claimed with respect to the taxpayer’s federal income tax; 
  • the amount of excluded FSI is limited to the amount of foreign source income otherwise included in net income or total receipts; 
  • any taxpayer claiming an FSI exclusion based on a foreign tax credit must file an amended Colorado return to report any change to the amount of the FSO exclusion, and any additional Colorado income tax due as the result of a redetermination of federal tax may be assessed and collected at any time. 

Observation: A significant element in the Rule Changes is requiring the FSI exclusion calculation to be performed on an income-type by income-type basis. The new regulation also describes how to calculate the federal tax rate (which the rules provide is performed without consideration of credits), which was not clear in the past. 

Section 78 

The Rule Changes adopt new Rule 39-22-304(3)(j), which provides the following: 

General rule 

Colorado allows a subtraction for Section 78 amounts. The subtraction is limited to the amount treated as a dividend and included in a C corporation’s federal taxable income under IRC Section 78. The subtraction is not allowed for any part of an amount treated as a dividend pursuant to IRC Section 78 that is deducted in the calculation of federal taxable income. 

Coordination with Section 250 

No subtraction is allowed for any amount treated as a dividend pursuant to IRC Section 78 that is: 

  • attributable to GILTI pursuant to IRC Sections 951A and 960(d), and 
  • deducted, pursuant to IRC Section 250(a)(1)(B)(ii) [the Section 78 amount included in the 50% GILTI deduction], in the calculation of federal taxable income. 

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Ed Geils

Ed Geils

Global and US Tax Knowledge Management Leader, PwC US

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