The first quarter of 2022 finds businesses grappling with lingering supply chain issues, serious inflation worries and a COVID-19 pandemic entering its third year. These are not only business concerns, but also tax planning challenges.
The tenuous efforts by Democrats to resurrect tax reform only adds to the planning uncertainty. After initial negotiations over President Joe Biden’s Build Back Better platform collapsed before the holidays, many tax executives relaxed, counting on the status quo to prevail. This is a mistake.
Significant developments still have the potential to drive major tax planning challenges and opportunities. For one, Democrats are still hoping to pivot to a smaller version of their agenda, and it could still include major tax initiatives. Even without legislation, tax laws are changing in significant ways. Past changes affecting revenue recognition, interest deductions, and research cost recovery are only now taking effect. Major global tax agreements will soon begin affecting multinational companies. In addition, external factors like remote work, inflation, supply chain disruption and economic volatility all have major tax implications.
Taxpayers should be proactively addressing these issues, not waiting and watching. A recent Grant Thornton survey of tax executives found that nearly 50% are either changing their planning in response to legislation or re-evaluating their tax strategy based on recent events. The top tax considerations for businesses and investors in 2022 include:
- Debt restructuring – Many companies are reassessing their debt arrangements as inflation and interest rates rise. The phase out of the London Interbank Offered Rate (LIBOR) may also force many companies to adjust debt instruments. Restructuring debt can trigger significant tax consequences, and a new law change tightening the limit on interest deductions under Section 163(j) could affect plans.
- R&E amortization – New rules for amortizing research and experimentation (R&E) expenses are in effect for 2022. While there’s still a hope for a retroactive fix, the timing and outcome are not certain. Companies in industries with heavy investments in research may need to begin the challenging task of identifying the affected costs before first quarter financial statements and estimated tax payments are due.
- International planning – The Biden administration helped broker major global tax agreements over the past year. Even if domestic legislation fails, international tax developments will continue to affect multinational tax planning. The IRS has also recently released important regulations that impact foreign tax credit planning.
- State and local tax upheaval – The shift to remote and hybrid work has created challenges related to how employers and their employees are subject to state and local income taxes. During the pandemic, many states offered temporary administrative relief and guidance addressing employee withholding and reporting rules. With this guidance expiring, businesses should be watching how states deal with continuing remote and hybrid working arrangements. Businesses should also be assessing how shifting arrangements affect the tax treatment of travel and commuting costs and payments for expenses related to employees working from home.
- Revenue recognition – The Tax Cuts and Jobs Act made a major change to how audited companies (businesses with applicable financial statements) recognize revenue for tax purposes. Final regulations are now required on 2021 returns, so businesses must move quickly to understand and implement the rules.
- R&D credit refunds – New IRS documentation requirements for R&D credit refund claims could impose a substantial burden on taxpayers. Businesses looking to amend returns to claim R&D credits for past years should quickly evaluate their methodology for computing and substantiating the credit to ensure they can provide the required information for each separate business component.
- Tax accounting challenges – Law changes on R&E amortization and interest deduction limitations could have a material impact on businesses making large research investments or heavily leveraged companies. Some businesses will need to evaluate the potential impact to deferred tax assets and effective tax rates as early as the first quarter of 2022. Companies may also need to adapt their systems, processes and internal controls to account for these changes, along with the new financial statement disclosure rules on government assistance.
- Staffing issues – Many sectors are facing a worker shortage, and tax departments are also feeling the crunch. This is an ideal time to look at how data transformation and analytics can make workflows faster and easier. The difference between manual data preparation and automated data transformation can be seconds versus hours.
- Pass-through tax compliance – New reporting requirements will complicate partnership returns this year. Schedules K-2 and K-3 will require partnerships and S corporations to report significant new international tax information, though there is some transition relief for 2021 returns.
- Estate and gift tax opportunities – While the legislative proposals to crack down on transfer tax planning is stalled for now, there is still reason to act quickly. Many estate and gift tax strategies hinge on the ability of assets to appreciate faster than interest rates prescribed by the IRS. Inflation is likely to soon push interest rates higher, as well as the values of some assets. In addition, the current lifetime exclusion amount (which reached $12,060,000 in 2022) is scheduled to be cut in half in 2026.
Many of these issues require immediate action, especially those that need to be addressed on the 2021 tax returns or first quarter interim period financial statements and estimated tax payments for 2022. The top 10 planning considerations for 2022 are discussed in more detail below.
Historically low interest rates have created a liquidity boom over the last several years, but the flow of cheap cash might soon be slowing. Interest rates are expected to climb as the Federal Reserve battles inflation.
Many businesses are looking to lock in rates now. According to data from Refinitiv going back to 2000, companies issued a record $532 billion in debt in January. Many companies will also be forced to adjust debt agreements that reference LIBOR, which may be phased out by the end of 2021. Businesses evaluating their debt arrangements should consider the potential tax impact of any modification of existing debt, and should model whether they will be able to deduct their interest expense, including a new tighter limit in 2022 under section 163(j).
Debt modifications can create cancellation of debt (COD) income if they are considered “significant modifications” under IRS regulations. 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.
Businesses that must modify debt instruments and other financial contracts to transition away from LIBOR and other interbank offered rates (IBORs) to alternative reference rates may avoid harsh tax consequences under recent regulations from the IRS. The recent regulations are generally intended to minimize the impact of any modifications to contract terms solely due to the phaseout of LIBOR and other IBORs. However, the analysis can be complex if there are contemporaneous modifications that are not covered by the regulations. See our latest writeup for more information on the LIBOR guidance and our full article for more information on debt modifications.
The ability to deduct interest for tax purposes is also an important consideration. The deduction for net interest expense is generally limited to 30% of adjusted taxable income under code Section 163(j), which was added by the Tax Cuts and Jobs Act (TCJA). Until this year, adjusted taxable income was generally equivalent to earnings before interest, taxes, depreciation and amortization (EBITDA). For tax years beginning in 2022 or later, depreciation and amortization must be included, lowering adjusted taxable income for purposes of the limit. Lawmakers are considering retroactively postponing this change, but the outlook is uncertain. Businesses should evaluate whether their 2022 interest deduction could be limited under the new calculation, and assess the potential impact on other items on the return.
Research investment represents a significant expense in many industries, including manufacturing, technology, and the life sciences. Under a TCJA change effective for tax years beginning in 2022 and later, domestic R&E costs under Section 174 must now be amortized over five years instead of being expensed. Since a midyear convention must be used, this would effectively reduce the deduction for these domestic R&E costs in 2022 by 90%. Foreign R&E must be amortized over 15 years under the new rules.
Many companies have been waiting to do the hard work of identifying these costs in hopes of a legislative fix. A recent Grant Thornton survey of tax professionals found 17% consider this their top legislative tax priority. There is certainly broad bipartisan support among lawmakers to retroactively postpone the effective date of this change, but the legislative process is never guaranteed. It is also unclear when a fix may come, and time may be running out for companies. First-quarter interim period financial statements and estimated taxes for 2022 will be due soon.
Financial statements must be prepared based on current law, and this provision may create a significant book-tax difference and deferred tax asset for companies with deep R&E investments. It also has the potential to impact effective tax rates if a valuation allowance is required for the deferred tax asset or due to the indirect effects on other calculations, including the interest expense limitation under Section 163(j), the base erosion and anti-abuse tax (BEAT), global intangible low-taxed income (GILTI), or foreign-derived intangible income (FDII). This leaves companies little time to perform the difficult task of calculating affected expenses.
Significant efforts may be required to properly identify the research costs under Section 174, which is much broader than the definition of research for the R&D credit. The R&D credit requires activities to meet a “process of experimentation” and a “technological in nature” test, while R&E under Section 174 must only meet an “uncertainty” requirement. Section 174 also requires the inclusion of all costs incident to the research, including indirect costs such as rent and depreciation. The R&D credit only allows for wages, supplies, and contract research expenditures. In addition, taxpayers can no longer choose to amortize or capitalize R&E costs over 10 years under Section 59(e) and will not be able to deduct certain software development costs.
There may be opportunities to mitigate the impact. Businesses can consider whether certain costs remain deductible under Section 162, though this will preclude those costs from being included in the R&D credit calculation.
While domestic international tax legislation remains stalled for now, global changes and IRS activity continue to drive tax planning opportunities and challenges.
The Organisation for Economic Co-operation and Development (OECD) reached major global agreements this year under both pillars of its framework for addressing base erosion and profit shifting. Pillar One is largely meant to address digitization, and the new agreement would allow countries to tax a share of profits from digital goods and services consumed in a jurisdiction even when the taxpayer has no physical presence there. The new rules would also require multinationals to register and pay tax where their economic activities create value, including on e-commerce sales initiated outside the jurisdiction.
This reallocation of profits under Pillar One would generally only affect multi-nationals with 20 billion euros in global revenue and pre-tax profit margin of more than 10%. There are also exclusions including for regulated financial services and extractive industries. For now, Pillar One reallocation is estimated to only apply to around 100 corporate giants worldwide, though the OECD could review and reduce the qualifying threshold in coming years. The scope could also be affected by the implementing legislation in different countries.
On the plus side, the potential implementation of Pillar One is intended to put an end to the patchwork of unilateral digital taxes, but countries must agree to forgo taxes on companies not meeting the income threshold for the reallocation rules. Signatory countries have pledged to pass Pillar One rules into legislation in 2022 and bring them into force in 2023, but there are major questions on whether many countries can meet that timing. For instance, implementing Pillar One in the United States would likely require a two-thirds majority in the Senate for tax treaty changes, which appears difficult in the current political climate.
Pillar Two would impose a top-up minimum 15% corporate tax across all countries and make it much harder to minimize taxes by recording profits in low-tax jurisdictions while recording the costs in high-tax counterparts. The threshold for qualifying for the Pillar Two minimum tax floor is much lower than Pillar Two: a 750 million euros global turnover.
Pillar Two has a potentially smoother road to implementation across member countries, but the GILTI regime in the U.S. is unlikely to considered compliant without the legislative changes Biden has proposed. As a result, certain U.S. multinationals could be taxed under both the GILTI system and the Pillar Two system with limited or no recourse, such as foreign tax credits to alleviate double taxation. For affected businesses, Pillar Two will require rethinking group structures and transfer pricing. In practice, tax strategies and value chains may need to be re-aligned with updated business models.
Finally, the IRS released new foreign tax credit (FTC) rules that significantly alter many aspects of the FTC landscape and will potentially restrict taxpayers’ ability to credit foreign taxes, including digital service taxes, withholding taxes on fees for technical services, certain royalties, and other taxes imposed under foreign sourcing rules that are not substantially similar to U.S. equivalent rules. Multinationals should take a fresh look at the foreign law basis for income taxes claimed as an FTC, non-U.S. local tax credit incentives, and the amended allocation and apportionment rules for certain disregarded payments. See our full article for more information on the FTC regulations.
State and local tax planning
COVID-19 created an unprecedented disruption to the workplace, and employers pivoted quickly to remote and hybrid working arrangements. Many states responded by issuing temporary emergency guidance addressing the income tax treatment of employees working from a different state than their historic work location. With the pandemic beginning to recede, much of the temporary guidance has expired. But hybrid and remote work have proven popular and lasting.
Businesses must evaluate how these permanent shifts in workplace arrangements will affect income tax withholding and reporting now that much of the temporary relief has expired. At the same time, businesses will need to track states’ efforts in adopting legislative changes to their income tax withholding policies in response to widespread remote work, along with how the state tax authorities interpret these changes in their published guidance. The evolving situation will present challenges for any businesses with employees or operations crossing state lines. Employees should also consider the tax treatment of travel and commuting costs and the payment of expenses related to employees working from home.
Pass-through businesses, meanwhile, may have opportunities to help their owners work around the $10,000 cap on the federal state and local tax (SALT) deduction. More than 20 states have enacted regimes that allow pass-through businesses to deduct state and local taxes at the entity level in exchange for a credit or exemption from state tax on the pass-through income of owners. This allows a business to fully deduct state tax for federal purposes against the distributive share of owner income, rather than having owners pay tax and take a limited SALT deduction at the individual level. Several additional states may soon be enacting similar laws. Whether electing into these regimes makes sense depends on a variety of factors, including state tax credit rules, the mechanics of each pass-through entity tax regime being evaluated, a variety of potential Federal income tax implications, and the prospects of federal legislation providing SALT cap relief. For all the top SALT issues for 2022, see our full article.
New rules for recognizing revenue will require nearly all businesses using the accrual method of accounting and preparing applicable financial statements (AFS) to make accounting method changes on 2021 returns. This includes all public companies, as well as private companies who prepare an AFS to fulfill shareholder, partner, or government reporting requirements.
Although the new rules were created by the TCJA, final IRS regulations generally are effective for tax years beginning in 2021, along with complex procedures for implementing the new methods. Generally, the new rules require affected companies to recognize revenue for tax purposes no later than they do for their financial statements—which may seem on its face like an administrative relief to match tax to book, but actually adds additional complexity and burden to the analysis.
For example, the IRS regulations contain many adjustments to the financial statement amounts reported and a number of exceptions. In addition, many companies are already recognizing book revenue differently than in the past under new recognition rules for financial statement purposes under ASC 606. The new tax requirements generally will not apply to items of gross income governed by so-called special methods of accounting, including rules for installment sales, long-term contracts, leases, mark-to-market items, and M&A transactions.
The good news is that regulations offer method changes in some areas that may be favorable. All businesses affected by the rules should be preparing to comply with the regulations on their 2021 returns and evaluating their accounting methods for savings opportunities. See our full article for a deeper dive into the new rules.
R&D credit refunds
The IRS recently released controversial guidance imposing significant reporting and documentation requirements for any taxpayers amending returns to claim an R&D credit refund. Under the new rules, taxpayers will need to identify all research activities, all individuals performing an activity, and all information each individual sought to discover on a component-by-component basis. Taxpayers will also be required to provide total qualified employee wage expenses, supply expenses, and contract research expenses. The facts must be backed by a declaration signed under penalties of perjury.
The new requirements apply to all claims filed after Jan. 10, 2022, but during a one-year transition period, taxpayers will have 45 days to perfect claims before any final IRS determination. Taxpayers will need to evaluate their methodology for computing and substantiating the research credit to provide the required information with the amended return. This is particularly important for taxpayers that rely on a cost-center or hybrid approach to ensure that the appropriate analysis by business component is performed and documented for the refund claim to be valid. Statistical sampling may significantly reduce the burden for many taxpayers. See our full article for more details.
Tax accounting challenges
Accounting for income taxes is often a major challenge in financial statement preparation and disclosures, and is only getting more difficult with the bevy of recent law changes. As mentioned above, the requirement to amortize R&E expenses could have a material impact on the financial statements of companies making deep research investments. Heavily-leveraged companies could also need to calculate the impact of the unfavorable changes to Section 163(j). Both of these issues could create significant changes to deferred tax assets, or even change effective tax rates depending on the need for a valuation allowance or how they may indirectly affect other tax calculations like GILTI, BEAT, and FDII.
In addition, the Financial Accounting Standards Board (FASB) recently issued rules (ASU 2021-10) intended to increase transparency on certain types of government assistance. The new disclosure rules apply to all entities except certain not-for-profit entities and employee benefit plans. The new rules cover assistance accounted for under a grant or contribution model, but only when it is not otherwise accounted under existing guidance. While government assistance falling under ASC 740, Income Taxes, is outside the scope, other tax-related government assistance for things like sales and use tax, payroll tax, and property tax may be covered.
If the government assistance is within the scope of the new rules, the following disclosures are required in the notes to the annual financial statements:
- The nature of the transactions, including a general description and the form (cash or other assets, for example) in which the assistance has been received
- The accounting policies used to account for the transactions
- The line items on the balance sheet and income statement affected by the transactions and the amounts applicable to each financial statement line item
Furthermore, an entity is required to disclose information about the significant terms and conditions of transactions with a government, which may include:
- The duration or period of the agreement
- Any commitments made by the parties
- Provisions for recapture, including the conditions that allow recapture
- Other contingencies
The new rules are effective for financial statements issued for annual periods beginning after Dec. 15, 2021, with early adoption permitted. These rules may require changes to systems, processes and internal controls to track, capture and validate the information subject to disclosure.
Data automation and analytics
Tax departments are under tremendous pressure to do more with less. Tax laws are changing at a historic pace while a volatile economic climate is driving major business changes. Tax accounting and compliance together require significant investments in resources, and the tax industry is not immune to widespread workforce shortages.
There may be opportunities to dramatically improve both efficiency and product. Many tax departments at even the most sophisticated businesses are still dedicating most of their time to basic number crunching and repetitive processes. Tax functions may rely heavily on Excel spreadsheets, experience poor or nonexistent integration between data sources and workpapers, or employ redundant data gathering for different uses.
Data automation and analytics could be the solution. The difference between manual data preparation and automated data transformation can be seconds versus hours. Once data is prepared, visualization can help businesses see into the data, instead of hunting for the story. This can help tax departments prepare data in a faster, better way for tax deliverables, audit support, reports and presentations.
There are many other specific areas that can benefit from automation, including tax engines for indirect tax like domestic sales and use taxes and global value added tax.
Pass-through tax compliance
The IRS is requiring partnerships and S corporations to perform new international tax reporting on 2021 returns. These passthrough businesses must report a variety of information on new Schedules K-2 and K-3, including details related to international transactions, FTC limitations, and information on Passive Foreign Investment Companies and Qualified Electing Funds. There is transition relief, but taxpayers must establish “to the satisfaction of the Commissioner” that they made a good faith effort to comply. This new reporting may require businesses to make changes to their current systems and processes to track and provide the required information in a different way, collect additional information from partners or shareholders, or modify agreements to facilitate information sharing. Our full article has more information.
Estate and gift tax opportunities
Democratic efforts to crack down on transfer tax planning have stalled, but are not yet dead. Even if these proposals don’t gain traction in the near term, there are still reasons to move quickly on estate and gift tax planning. Many strategies hinge on the ability of assets to appreciate faster than interest rates prescribed by the IRS. Interest rates are still at historic lows, but might not be for long. Inflation is a growing concern, and the Federal Reserve is signaling that they are likely to begin pushing up interest rates in response. Inflation could also push up asset values, so it makes sense to act now.
In addition, the current favorable estate, gift, and generation-skipping transfer tax lifetime exclusions, which reached $12,060,000 in 2022, are scheduled to be cut in half in 2026 without any new legislation. The IRS has issued helpful guidance allowing taxpayers to leverage the current exemptions without fear of future changes clawing back the benefit. The rules provide that the estate tax can be determined using the exemption amount allocated to gifts made during the increased exemption period or the exemption amount at the time of death, whichever is greater. Taxpayers who do not take advantage of the increased exemptions with gifts before 2026 could forfeit the benefit of the increased exemptions. Democrats could also resurrect legislation curbing transfer tax planning much earlier.
Taxpayers should immediately begin addressing the planning considerations that must be reflected on 2021 tax returns. It may also be important to act quickly on planning opportunities for 2022 and beyond. The earlier tax planning is built into business planning, the more effective it is. Several 2022 issues may also need to be resolved before first quarter estimated tax payments and financial statements are due. Finally, taxpayers should continue to monitor the tax legislative outlook closely. Democratic ambitions have recently hit roadblocks, but significant changes remain possible.