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Treasury issues rule on state tax reductions and federal aid

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May 2021

In brief

The US Treasury Department has published an interim final rule on the administration of state and local fiscal recovery funds established under the American Rescue Plan Act of 2021 (ARPA). The interim rule, effective May 17, 2021, includes guidance on an ARPA provision prohibiting the states from using fund disbursements to “either directly or indirectly offset a reduction in the [state’s] net tax revenue.”

Action item: States will have to analyze the impact of Treasury’s guidance on continuing budget discussions and pending legislation, as well as regulatory projects and administrative guidance. The guidance addresses some states’ concerns, particularly those with improving economies. Businesses should monitor tax measures potentially impacted by this provision and any changes to Treasury guidance on the issue.

In detail

On March 11, President Biden signed into law the ARPA, a $1.9 trillion package including approximately $350 billion for state, local, and tribal governments and territories. Of this, over $195 billion is to be provided under a funding formula for certain costs incurred through December 31, 2024 by the 50 states and the District of Columbia.

The legislation restricts states’ use of the $195 billion to certain areas, including responding to the COVID-19 public health emergency or its negative economic impacts, paying eligible essential workers, providing government services impacted by a reduction in state revenue, or making necessary investments in water, sewer, or broadband infrastructure.

The legislation also requires Treasury to recoup fiscal recovery funds disbursed to the states to the extent they are used to either directly or indirectly offset a reduction in net tax revenue resulting from a change in law, regulation, or administrative interpretation that reduces any tax or delays the imposition of a tax or tax increase. (See PwC’s Insight for more details on ARPA’s restrictions.)

Multistep process for determining recoupment amounts

Treasury’s guidance lays out a four-step process for determining if fiscal recovery funds have been used to offset a reduction in net tax revenue.

1.     Identify covered changes that reduce tax revenue. For each reporting year, a recipient state must identify and value “covered changes” that it predicts will reduce tax revenue in a given reporting year, “similar to the way it would in the ordinary course of its budgeting process.” 

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 not prescribed prior to the start of the covered period. There are several exceptions, including an automatic rate change dictated by prior law, IRC conformity, or a changed administrative interpretation to correct a prior inaccurate interpretation.

For state fiscal years ending in 2021, the first reporting year will be a partial year beginning on March 3, 2021 (the beginning of the ARPA’s “covered period”) and running through the end of the state’s fiscal year (e.g., June 30, 2021 for most states).

2.     Determine if revenue reductions exceed the de minimis amount. The recipient state next must add together the covered changes reducing revenue identified in the first step. If the total value of these revenue reductions is below Treasury’s “de minimis level,” then no recoupment is required for that reporting year. The de minimis level is one percent of the state’s 2019 fiscal year tax revenue, indexed for inflation.

3.     Apply the “actual tax revenue” safe harbor. If the state’s total revenue reductions are not de minimis, the state still may qualify for a safe harbor. If actual tax revenue for the reporting year is greater than the state’s inflation-indexed 2019 fiscal year tax revenue, Treasury will deem the state not to have a net tax revenue reduction for the reporting year and therefore not to be subject to recoupment.

4.     Offset revenue reductions by tax increases and spending cuts. If the state exceeds the de minimis amount and fails to meet the safe harbor, it still may offset its total revenue reductions by certain other funding sources. The first category of eligible offsets are tax policies that the state predicts will increase general revenue in a reporting year. The second category of eligible offsets are state spending cuts. However, spending cuts in areas where fiscal recovery funds are applied cannot offset tax revenue reductions.

“Organic revenue growth.” The resulting amount of tax revenue reductions offset by tax increases and spending cuts is the amount potentially subject to recoupment. However, the amount subject to Treasury recoupment is capped by the amount that actual tax revenue has declined relative to the 2019 inflation-adjusted baseline. For example, where a state’s covered changes reduce tax revenue by $1 billion in the covered year but the state’s tax revenue increases by $500 million due to ‘organic economic growth,’ then only $500 million is subject to recoupment.

The takeaway

Treasury’s guidance addresses several issues, including that net tax reductions are determined in the aggregate and that increased tax receipts due to economic growth will act as a limit on recoupment.

At the same time, Treasury’s guidance could be seen as disproportionately impacting states that have not enjoyed an economic rebound. These states may want to provide tax relief and incentives to promote recovery, without providing offsetting tax increases or spending reductions from non-ARPA programs. Further, since the restrictions are evaluated on an annual basis, states that this year determine they are not impacted could be subject to recoupment in subsequent years, based on future revenue levels and policy changes.

Several states have filed lawsuits challenging the ARPA aid restrictions, and some have pledged to continue their litigation despite the recent Treasury guidance. Comments on the interim final rules are due by July 16, 2021.

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Contact us

Peter Michalowski

State and Local Tax Leader, PwC US

Rohit Kumar

Principal & Co-Leader Washington National Tax Services, PwC US

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