Companies should deduct costs upfront, while they still can
Even in a stable environment, uncertainty complicates tax planning. But when volatility and increased global risk enter the picture, complications grow exponentially. Manufacturers are facing the convergence of inflation and supply chain disruptions, along with tax issues, including unfavorable new changes requiring the amortization of research and experimentation (R&E) costs and tightening the limit on interest deductions. International tax proposals aligned with the OECD’s Two-Pillar approach could be even more transformative if Democrats manage to resurrect parts of the stalled Build Back Better Act (BBB).
Manufacturers form new supply chain links
Supply chain issues have thrown some manufacturers’ tax planning into disarray, said David Sites, who leads Grant Thornton’s International Tax practice. “People are saying, ‘I used to get X from person A, and now I get X from person C. It’s in a different jurisdiction. I’ve got a completely different trail for that product.’”
Sites expects those challenges to continue in the near term, noting that companies have begun to adapt. “Some of the traditional tax planning isn’t going to get it done anymore. It’s become a much more dynamic environment,” Sites said.
A dynamic environment exists at CF Industries, a global manufacturer of hydrogen, nitrogen products for clean energy, and other industrial applications. The company’s vice president of tax, Jeff Olin, offers an example. “China takes 20% of the fertilizer market off the market; the Russia-Ukraine war takes off another 20%. All of a sudden, we are a massive exporter.
Companies are deploying different transfer pricing approaches to supply chains, Sites said. The OECD’s Two-Pillar plan (see below) would add a transfer pricing safe harbor for certain marketing and distribution activities, referred to as “Amount B” under Pillar One.
“That could take a tremendous burden off a lot of organizations that have significant marketing and distribution activities,” Sites said. “As companies start to plan, you’ll see a rejiggering of supply chains, with more distribution and market activities carved out and profits shifted to lower-taxed or tax incentive-type jurisdictions.”
The impact of inflation
Several aspects of inflation are affecting CF Industries, Olin said. “The ultimate consumer of our product, the farmer, is facing inflation in terms of their input. Fortunately, corn has inflated to $7 a bushel, and beans to $17 a bushel, so the percentage they spend with us is still a reasonable percentage.” Olin added that CF Industries’ largest input is natural gas, which is partly affected by inflation.
Interest in methods like last-in, first-out(LIFO) method of accounting has increased along with inflation, said Dustin Stamper, managing director of the Washington National Tax Practice at Grant Thornton. “In an inflationary period, you’re getting to deduct the most recent and the highest cost inventory. There can be a flip side danger to that if you’ve been on LIFO for a while, and you run into supply chain disruption. Then you’re dipping back into old inventory at a much lower cost.”
R&D change: Expense amortization
Manufacturing accounted for 58% of domestic R&D spending in 2019, according to the National Center for Science and Engineering Statistics. That means tax law changes to R&D investment are a major concern in the industry. One of the biggest new issues is the requirement that beginning Jan. 1, 2022, companies must capitalize and amortize R&E expenses under Section 174 over five years instead of expensing them. The change came from the Tax Cuts and Jobs Act in an attempt to offset the revenue lost from cutting the U.S. corporate tax rate.
“We’re working with increased Section 174 expenses (at CF Industries),” Olin said. “So, for us, amortization is an impact in 2022. We are moving from being a traditional agricultural producer of nitrogen ammonia into clean and green energy. We believe those are R&D credit, (Section) 174-qualified research expenditures, so we’re going full forward on the R&D credit. My viewpoint is [the amortization requirement] will change.”
Adjusted taxable income, bonus depreciation revisions
The limit on interest deductions is also getting tighter on manufacturers. Under Section 163(j), companies can take an interest deduction of only up to 30% of adjusted taxable income. Beginning in 2022, adjusted taxable income must include amortization and appreciation, Stamper said. “So, for capital-intensive businesses like manufacturers, that lowers taxable income and lowers where the threshold kicks in, at the same time interest rates are starting to rise,” he added.
In addition, 100% bonus depreciation expires at the end of 2022 and is scheduled to decrease to 80% in 2023. It will keep drawing down in subsequent years, Stamper said. “In a time of inflation – when deferred tax benefits, deferred tax attributes, will lose value over time – that’s of concern.”
Global movement to enact minimum taxes
International tax agreements are slowly moving forward and would affect manufacturers with a multinational footprint, Stamper said. The OECD’s Two-Pillar approach includes new taxing rights for certain market jurisdictions along with a global minimum tax aimed at income subject to a rate lower than 15%.
Pillar Two, the global minimum tax, contains two mechanisms designed to combat low-taxed income. First, the income inclusion rule (IIR) would require parent companies to apply a top-up tax on their subsidiary’s low-taxed income. Where the IIR is not applied, the under-taxed profits rule (UTPR) would require non-parent group members to increase their tax burden if low-taxed income exists elsewhere in the group.
In reaction to these rules, some jurisdictions, including those in the U.S., have proposed a qualified domestic minimum tax, which would allow the host country to step in and apply a minimum tax to its residents, precluding other jurisdictions from capturing the minimum tax under the IIR or UTPR.
“The proposal says that if we adopt this tax, we will essentially tax our companies back to 15%,” Sites said. “This domestic minimum tax is potentially a sleeper for a lot of organizations that have enjoyed significant benefits from credits, accelerated deductions and so forth.
“Once that Pillar 2 ball starts rolling, the heat on Congress will be turned up,” Sites added. “There will be a lot of questions about why we are letting a subsidiary company collect revenue for undertaxed U.S. companies.” This dynamic could push adoption forward in the U.S. to mitigate these risks.
Sites foresees a trend of companies in high tax jurisdictions that are well above that 15% mark trying to limit exposure to that tax. “That’s because over 15% doesn’t help them.”
Tax planning strategy in this environment
The webcast panelists described a tax strategy that corresponds to the current environment. “We are seeing tax planning in which companies are looking to avoid capitalization, amortization, and depreciation, and deduct as many costs as they can upfront,” Stamper said. “That’s because of tax attributes potentially losing value over time.”
Sites agrees. “The name of the game is, get your deductions now, while they’re worth something. Try not to defer them and manage that liability side.”