What’s old is new: Tax planning for businesses heading into 2024

Cost of borrowing

The era of cheap money is over. Although inflation has eased, debt is still significantly more expensive than many companies became accustomed to over the last decade. Interest rates are changing how companies think about funding investments with borrowed money, and the tax implications should be part of that assessment.

A change in tax law will compound the impact of higher interest rates and make it harder for companies to fully deduct their interest expense. The deduction for net interest expense was generally limited to 30% of adjusted taxable income under Section 163(j) under the Tax Cuts and Jobs Act. Previously, adjusted taxable income was similar 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 to an amount similar to EBIT. Although taxpayers can carry forward their unused interest deductions, the 30% limit will continue to apply, so the disallowance can be effectively permanent for some companies.

Fortunately, there are planning alternatives. Taxpayers may have opportunities to reduce the amount of interest expense subject to Section 163(j) by allocating interest to the research and development, production, construction or acquisition of a wide range of tangible and intangible property. Once recharacterized to another asset, the interest becomes part of the cost of that asset and is recovered using the accounting method applicable to that item. For example, if interest is recharacterized as inventory, it would be recovered through the costs of goods sold.

How interest is allocated can affect how quickly the cost is recovered, so it’s important to model out interactions to see what levers can be pulled to achieve the best tax result (see our previous article for a more detailed discussion). It’s also important to keep in mind that Congress is still considering legislation to reverse the change to Section 163(j), so make sure to monitor congressional action as we head into the new year.

Research and equipment recovery

Section 163(j) isn’t the only deduction getting worse. For tax years beginning in 2022 and later, domestic R&E costs under Section 174 must be amortized over five years instead of expensed. Since a mid-year convention must be used, this effectively reduced the deduction for these domestic R&E costs in 2022 by 90%. Foreign R&E must be amortized over 15 years.

Many businesses hesitated to address this provision in the hope that Congress would reverse it legislatively. Most taxpayers were finally forced to implement it when filing 2022 returns, so companies should now have completed the significant work of identifying R&E costs under Section 174. Now is the time to look at more proactive planning. There may be one last chance for lawmakers to provide retroactive relief before the end of this year, so watch out for potential legislation.

The IRS released important guidance on how to apply these rules just weeks before returns were due for many calendar-year corporations. The guidance offers important insight into several important areas, including the interaction with long-term contracts under Section 460, the definition of software development, the treatment of research performed under contract, and cost-sharing arrangements. Taxpayers should analyze the new rules, which are proposed to be applicable for tax years beginning after Sep. 8, 2023. Some of the rules provide favorable results, while others could present challenges and compliance burdens.

For investments in tangible property, bonus depreciation is also shrinking. Property placed in service this year can no longer be fully expensed and is instead eligible only for 80% bonus depreciation, with the rest of the cost recoverable over the normal depreciable period. This treatment is scheduled to diminish over time, with the bonus rate dropping to 60% for property placed in service in 2024, 40% in 2025, and 20% in 2026. Bonus depreciation is scheduled to disappear entirely in 2027. 

Losing 40% of a first-year deduction can be painful for companies that invest heavily in their physical footprint, but there are planning opportunities. An analysis to identify costs that can be considered repairs has always been valuable when looking at property that doesn’t qualify for bonus depreciation. With bonus depreciation at 60% next year, this repairs analysis could also now significantly accelerate the cost recovery of other types of property. Companies can also consider a broader cost segregation analysis, which identifies costs eligible for recovery as property with a shorter depreciable period. This effort can be paired with Section 163(j) planning to accelerate the recovery of any related interest expense.

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Pillar 2 global minimum tax

Multinational companies with 750 million euros or more in consolidated financial statement revenue in at least two of the previous four years can’t afford to ignore Pillar 2 any longer. While implementation is stalled here in the U.S., it is moving forward abroad, with initial rules taking effect as early as 2024.

Pillar 2 is designed to ensure large multinationals pay a minimum level of tax on income arising in every jurisdiction where they operate. The framework generally consists of three interlocking rules:

• Income inclusion rule (IIR): The IIR will allow parent countries to impose a “top-up” tax on earnings of foreign subsidiaries with effective rates below 15%.
• Under-taxed profits rule (UTPR): The UTPR denies deductions and uses other mechanisms to effectively impose additional tax on earnings with effective rates under 15% that aren’t covered by an IIR.
• Qualified domestic minimum top- up tax (QDMTT): The QDMTT “tops-up” tax on domestic entities to 15% before another country’s UTPR or IIR applies.

Global adoption will affect U.S. multinationals in significant ways. The foreign income of U.S. multinationals could be hit by QDMTTs and UTPRs in foreign jurisdictions, and could potentially be double-taxed in future years when relief for the U.S.’s global intangible low-taxed income regime expires. Domestic subsidiaries of foreign parents with domestic income taxed at an effective rate below 15% could also be taxed under the IIR of the parent’s jurisdiction. When transition relief expires in 2025 or 2026, any domestic income taxed at an effective rate below 15% could be taxed by the UTPR of a subsidiary jurisdiction. In addition, there may be financial statement implications, and affected companies will be required to perform detailed calculations and extensive reporting on a jurisdiction-by-jurisdiction basis.

Companies should start with an assessment to determine the potential applicability based on the revenue threshold, the entities in scope, and eligibility for any safe harbors. Modeling can allow companies to assess the impact and evaluate potential changes to their structure or operating model to mitigate bad results.

The complex computations will also require covered companies to spend substantial time gathering and analyzing data points on an annual basis, some of which may not be readily available. Affected companies should consider automation and software solutions to increase efficiency. Most taxpayers will also need a global network to assist with the preparation and review of returns in each jurisdiction.

Foreign tax credits

Finally, some good news. The IRS finalized regulations late last year that rewrote the foreign tax credit (FTC) rules and significantly restricted the ability of taxpayers to credit foreign taxes, including digital service taxes, withholding taxes on fees for technical services, and certain royalties. So, what’s the good news? After widespread complaints, the IRS in July effectively delayed the implementation of the final rules and will generally allow taxpayers to use a modified version of the rules in place as of April 1, 2021 (with the exception of digital services taxes). Companies that filed 2022 returns before the relief was available should analyze their FTC positions to see if there are opportunities to file for refund claims on an amended return.

Transfer pricing

Transfer pricing has rarely been more difficult thanks to shifting supply chains, sweeping international tax law changes, and increased global reporting requirements. Transfer pricing has also never been more important.

The growing exposure involved with transfer pricing issues is matched only by how pervasive it is. Multinationals are required to determine an arm’s-length transfer price for any cross-border transaction or agreement between related parties, including for goods, services, intangible property, rents and loans. This represents a staggering amount of activity. According to the U.S. Census Bureau, imports and exports between related parties surpassed $2 trillion last year, representing more than 40% of all import and export activity. And this doesn’t even include intercompany services, loans, or payments for intangibles.

The amount of tax at stake can be substantial. Some of the largest tax disputes in Tax Court history involve transfer pricing. The IRS has been successful in some of its recent litigation and is stepping up enforcement. These efforts will be aided both by $60 billion in new IRS funding and legislative changes driven by Pillar 2. With the IRS winning cases, taxpayers need to look more closely at whether their transfer pricing positions represent uncertain tax positions that must be reflected on financial statements.

The costs of a transfer pricing dispute can go beyond the adjustments in tax, or even the potential 20% or 40% penalties for valuation misstatements. Sizeable costs in professional fees and in-house resources are common due to how notoriously complex and difficult transfer pricing issues are to resolve. All transfer pricing disputes involve at least three parties affected by the outcome: the taxpayer and both countries affected by a change in the transfer price. Companies can consider alternative dispute resolution programs like administrative appeals, mutual agreement procedures, and advance pricing agreement programs to manage the complexity, ambiguity, and expense of a transfer pricing issue.

Public stock buyback tax

Public companies face a new 1% excise tax on the fair market value (FMV) of stock repurchases in 2023. The IRS is still working on guidance, but has said the tax will be remitted and reported annually with the Form 720 for the first quarter after the end of the tax year. This means any 2023 tax and the 2023 form will likely be due for calendar year taxpayers by April 30, 2024. Companies that will be affected need to move quickly to understand the impact.

The tax applies to corporations with stock traded on an established securities market, which includes corporations with stock that is traded on a national securities exchange. The tax may also apply to certain acquisitions of a foreign corporation’s stock. A repurchase is defined for this purpose as a redemption under Section 317(b), plus “economically similar” transactions. The tax could increase costs on many kinds of common stock redemption activity, including redemptions related to M&A and stock compensation plans. The new excise tax is not deductible for income tax purposes.

Under initial guidance from the IRS, the tax will cover a variety of corporate transactions, including acquisitive reorganizations, certain E and F reorganizations, and exchanges in some split-off transactions. The tax can also apply to redemptions of non-publicly traded stock, such as preferred stock, if the corporation has other stock traded on an established securities market.

There are important exceptions and exclusions. Stock issued effectively reduces the amount considered repurchased for purposes of calculating the tax. There are specific rules for determining the FMV of stock issued and repurchased. In addition, the following repurchases are excluded:

• Reorganizations within the meaning of Section 368(a) where no gain or loss is recognized
• Repurchases to the extent that stock is contributed to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan
• If the aggregate FMV of stock repurchased in a year does not exceed $1 million
• Repurchases by a dealer in securities in the ordinary course of business
• Repurchases by a regulated investment company (RIC) or a real estate investment trust (REIT)
• Repurchases that are treated as a dividend (to the extent treated as a dividend)

Planning for the tax is important. Different types of transactions can be treated differently under the current guidance. Some M&A transactions can give rise to a large increase in the tax base if they are recharacterized as a repurchase, so the tax should be considered as a part of transaction planning and structuring. Because stock issued by a corporation may offset stock repurchases during the year, companies should consider the timing of repurchases related to their stock issuances. Any excess of stock issuances cannot be carried forward and used against stock repurchases in future years.

State and local taxes

State and local taxes can be as important as federal taxes for many businesses. States and localities looking for new revenue sources are aggressively targeting service providers, digital goods and services and property taxes.

As we move farther and farther from the 2018 decision in South Dakota v. Wayfair, states continue to push the envelope with economic nexus provisions requiring sales and use taxes on services and licensing. Sales and use taxes are growing increasingly complex with the interplay between various states and evolving nexus rules. Consider performing a sales and use tax “reverse audit” to review your purchase records over the past several years to identify potential missed exemptions, misapplied rates and overpayments. The reviews can often generate significant refunds, as well as identify areas of exposure.

Many states are also looking at applying economic nexus concepts and unique sourcing rules to income and gross receipts taxes. In certain cases, such laws could require service providers to recognize revenue based on where the production costs for the services take place. This is a particularly relevant issue as hybrid and remote work arrangements become a permanent part of the workforce relationship.

Property taxes are also often a very large cost for any industry with a large physical footprint. These taxes, which are generally based on formulas that take the value of property into account, can be notoriously sensitive to inflation. Commercial property values took a big hit at the outset of the pandemic, but with people returning to cities to work at least part of the time, and a reimagination of what work could look like post-pandemic, these values are again increasing. Some of the increases may not be supportable. Businesses have a right to challenge valuations, and a property tax assessment can uncover significant savings.

IRS enforcement

Taxpayers across all industries and entity types should expect elevated scrutiny from the IRS over the next few years. The Inflation Reduction Act provided the IRS with $80 billion in new funding, and over 50% is earmarked for enforcement. The debt limit deal included a handshake agreement to reallocate $20 billion of that money to other spending priorities, but $60 billion is still a staggering sum compared to normal IRS funding. It represents more than four years of annual appropriations based on recent IRS funding levels, and it comes on top of regular annual funding with no restrictions on when it can be spent.

The increased enforcement may come more quickly than some taxpayers expect. The IRS has already significantly expanded its workforce in the last two years and is actively recruiting 3,700 new auditors. Much of the activity will be focused on partnerships and high-net-worth individuals, but no population of taxpayers will be unaffected. Even the largest corporations have seen their audit rates fall significantly in the last few years and should expect them to rebound in the next few years.

The IRS is already providing information on where it will focus resources, including transfer pricing, the overstatement of the cost of goods sold, the employee retention credit, and the R&D credit.

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R&D credit

The R&D credit remains one of the most valuable incentives available and offers benefits across a wide variety of industries. The credit is even more valuable with the new requirement to amortize R&E costs under Section 174 because many companies discovered they had qualified activities for which they had never taken the credit previously because they had not identified the research activities. Additionally, some taxpayers may no longer need to reduce either their R&D credit or the amount recovered under Section 174.

Section 280C(c) long required taxpayers to reduce their deductions under Section 174 by the amount of any R&D credit, or to reduce the R&D credit by the tax effect. The Tax Cuts and Jobs Act amended Section 280C(c), so taxpayers only need to reduce their capital account for future Section 174 expenditures to the extent that any R&D credit exceeds the deduction for those costs. For many companies, the deduction will exceed the R&D credit, meaning they can claim the full R&D credit without any reduction in the ability to recover Section 174 costs. Taxpayers should monitor this issue, however, as the IRS has not yet issued any guidance on interpreting the new statutory language.

Given the coming increases in enforcement activity, taxpayers should ensure they properly document and substantiate their R&D credit claims. The IRS has won several recent cases based on the failure of taxpayers to establish that “substantially all” of all the development activities constituted elements of the process of experimentation or that there was not sufficient uncertainty from the outset.

Companies claiming a credit should consider an R&D credit study. Some of the taxpayers who lost recent cases could potentially have preserved partial credits under the “shrink-back rule” if they had provided the documentation to apply their analysis to subcomponents of a project that the court’s found did not qualify as a whole. A full R&D credit study should not only identify and maintain detailed records, but also explore whether there are missed opportunities in areas identified by the need to capitalize Section 174 expenditures.

Energy tax credits

The IRA’s transformative new energy tax package can benefit taxpayers outside of the renewable industry and traditional energy supply chain. It’s never been more economical for ordinary companies to pursue renewable conservation and efficiency improvements especially those with ESG goals.

The energy cost savings together with the tax benefits can make a compelling case. Taxpayers can benefit even if they owe no tax, thanks to the ability to sell the credits. Taxpayers that aren’t themselves looking to pursue energy projects can evaluate purchasing credits as a tax mitigation strategy.

The energy incentives most likely to benefit taxpayers outside of the energy industry include:

• Investment tax credit: Section 48 generally provides a credit of 30% for investments in projects that generate electricity, including solar, wind and geothermal. Projects will generally be exempt from prevailing wage and apprenticeship rules unless they exceed 1 megawatt. There are also 10% bonus credits for domestic sourcing and for projects in specific geographic areas. Qualifying property has also been expanded to include dynamic glass, energy storage, microgrid controllers, and interconnection property. With the credit, microgrids and battery storage can be competitive with backup generator systems. Solar investments can also provide a healthy return.
• Qualified commercial clean vehicle credit: Companies with vehicle fleets can consider credits under Section 45W for plug-in electric vehicles. The commercial vehicle credit doesn’t suffer from the same stringent new battery and mineral sourcing requirements that are imposed on the consumer credit. The credit offers 30% against the cost of the vehicle (15% if it is a hybrid with an internal combustion engine), but is limited to the incremental cost over a similar gasoline-powered vehicle. For cars, trucks, and vans under 14,000 pounds, the credit will generally be capped at $7,500. Vehicles exceeding that threshold can be eligible for a credit of up to $40,000. The credit is fully refundable for tax-exempt entities.
  
• EV charging: Companies greening their fleets or looking to encourage electric vehicles can claim a 30% credit of up to $100,000 per charging station installed. The credit is limited to property placed in service in non-urban census tracts and census tracts eligible for the new markets tax credit.
  
• Building design incentives: Section 179D provides for an immediate deduction for energy-efficient HVAC, lighting and building envelope property such as windows and roofing. It offers as much as $5 per square foot to reward the construction of energy-efficient commercial buildings and is available for energy-efficient ground-up construction and energy-efficient retrofits of older buildings. The credit requires certification using specialized software.
  

Most of the new credits can be transferred, creating opportunities for project owners to monetize credits and for credit buyers to reduce taxes. The ability to sell credits is a novel concept in the federal space, and the market will be large and active. There are significant restrictions on the transfer transactions that can limit flexibility and create risk. 

The buyer of a credit retains significant risk if the IRS audits and disputes the amount of the credit or if there is a recapture from a change in ownership. Buyers and sellers will need to manage risk with indemnification clauses, insurance, and documentation to support the credit claim. The credits are complex and companies on both sides of the transaction may need to substantiate the underlying qualifications, including compliance with prevailing wage and apprenticeship rules and domestic sourcing.

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