The recent onset of rapid inflation is an unwelcome development that is having a widespread impact on businesses and tax planning. Agile companies should be shifting their strategies to address both federal and international tax considerations.
Most importantly, businesses will face an erosion in the value of tax attributes—like net operating losses—while deferred deductions for amortization and depreciation will similarly lose value relative to a non-inflationary environment. Planning can help businesses leverage deductions now before inflation devalues them, and certain accounting methods will become more attractive against rising prices and costs.
Inflation is also affecting the broader economy—particularly interest rates—creating unique tax planning challenges. Businesses should consider how rising interest rates could affect the limit on interest deductions under Section 163(j), intercompany cross-border lending, cash repatriations, and transfer pricing. Companies needing to rework debt arrangements as interest rates rise should also consider the tax consequences of debt modifications.
This piece is part of our series of articles covering the tax planning implications of inflation and will provide a deeper dive into federal and international planning considerations during a high-inflation period.
Tax assets
The value of any asset that is fixed in nominal terms will be eroded by inflation as the relative value of the dollar decreases. Tax attributes are no exception. Costs that must be capitalized, amortized, depreciated or deferred will be less valuable in future years when they can finally be used as deductions. Credit carryforwards and net operating losses will similarly be affected.
Businesses should consider planning options to accelerate deductions, and/or defer revenue, that can be used now. Companies have many options at their disposal to decrease taxable income through accounting methods, elections, and other tax planning strategies. Most companies employ dozens of separate accounting methods on everything from inventory and rebates to software development and prepaid expense. Identifying more favorable options—through, for example, a strategic accounting methods review—can result in a favorable adjustment that allows additional deductions to be realized in the current year, or additional revenue deferred to a later year.
For businesses with commercial real estate, cost segregation can be a powerful tool. There are often opportunities to identify and reclassify building assets that can be depreciated much more quickly than the 39-year period for most buildings.
Grant Thornton Insight:
Taxpayers experiencing rising inventory costs due to inflation could benefit by switching to the last-in, first-out (LIFO) method of accounting. Under the first-in, first-out (FIFO) method of accounting used by many companies, the earliest goods purchased or produced are considered the first goods sold. Switching to LIFO means that the most recently acquired goods are instead considered the first sold. In times of rising prices, these recently acquired goods will be the most expensive, reducing the cost of goods sold. Given how current inflation is driving substantial cost increases across many industries, the tax savings of switching to LIFO could be significant for many businesses.
Debt considerations
Interest rates have been steadily rising across the economy as the Federal Reserve looks to battle inflation. The tax consequences can be broad.
Interest deduction limit
Businesses evaluating their debt arrangements in light of rising interest rates should consider the potential impact of Section 163(j), which limits the deduction for interest expense to 30% of adjusted taxable income. For tax years beginning in 2022 or later, depreciation and amortization deductions must be included in the calculation, lowering adjusted taxable income for purposes of the 30% limit. This change along with rising interest rates could subject many new companies to the limit for the first time.
Lawmakers are considering retroactively postponing this change, but the outlook is uncertain—and a potential fix is not likely until after the November mid-term elections. Businesses should evaluate whether their 2022 interest deduction could be limited under the new calculation and should assess the potential impact on other items on the return.
Debt modifications
Low interest rates created a liquidity boom over the last several years as companies binged on cheap money. Some debt may be maturing as rates rise rapidly, and companies could be looking to adjust their financing pre-emptively to account for the new outlook. Businesses should consider the potential tax consequences for debt modifications. Any “significant modification” under IRS regulations can create cancellation of debt (COD) income.
The IRS regulations contain bright-line rules for when changes to yield, security, recourse or timing of payments represent a significant modification. Deleting or altering customary financial covenants is generally not a significant modification, but any fees paid with a modification must be assessed as a change in the yield. Significant modifications can result from:
- A change in the stated interest rate or rates
- Extending the maturity date when the principal is due
- Deferral of interest or principal payments over the life of a loan
- Entering into a forbearance agreement when a debtor is in default
- Converting existing debt into equity or making fixed payments contingent upon certain events
Significant modifications can create COD income to the extent old debt exceeds the issue price of the new debt instrument. If the debt is not publicly traded, the tax consequences may be limited as long as there is no reduction in principal and the rate is at least the long-term Applicable Federal Rate. The COD income from modifications of publicly traded debt is more significant and can often be material. The rules for determining whether debt is publicly traded can be complex, but a safe harbor rule treats any outstanding debt not exceeding $100 million as not publicly traded.
International considerations
Inflation and its corollary affects can have a significant impact on international tax planning structures. Rising prices due to inflation are not uniform across supply chains, and this can create issues with intercompany arrangements. These issues are only exacerbated by rising interest rates and fluctuating currency valuations.
A stronger dollar may drive down the value of foreign earnings when they are repatriated and create opportunities for loss planning. Rising interest rates can upend how much interest expense and interest income will be recognized by related parties in different jurisdictions under an intercompany loan. This may significantly change where income will ultimately be sourced and where tax is paid. In addition, the uneven impact of inflation around the world is causing price changes of wildly varying degrees across different jurisdictions. This can also change how much income or loss is expected in a specific country and disrupt transfer pricing arrangements.
Grant Thornton Insight:
Multinationals should reassess their international structuring and cross boarder arrangements by taking a comprehensive look at the potential combined impact of uneven price increases, rising interest rates, and currency fluctuations. The evolving landscape could prompt changes to transfer pricing agreements, debt sourcing decisions, and cash management and repatriation.
Next steps
Inflation is proving resilient, but agile tax planning can mitigate the impact to tax planning and even uncover opportunities. Businesses should look for favorable accounting methods in times of rising prices, carefully consider the impact of interest rates, and reassess their international tax planning.
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