Little guidance has been released for individuals working remotely in Oregon. However, that does not mean that employees should ignore the effects of their new working arrangements. For example, a taxpayer’s resident state usually taxes all their income, regardless of where it is earned. When a taxpayer works in more than one state during the year, the taxpayer must allocate their income to the respective state in which it was earned. The taxpayer will be entitled to claim a tax credit for income tax paid to another state, which reduces their taxes payable on their resident state return. Thus, if a taxpayer normally works in a different state than their resident state, they could incur penalties for not making sufficient tax payments in their home state because they will no longer be receiving a state income tax credit from the state where they normally work. Taxpayers should make sure they have changed their withholding requirements to ensure they do not incur penalties.
Corporate Activity Tax
- Insufficient funds due to COVID-19 that caused the business to not be able to pay a full quarterly installment.
- The impact of COVID-19 made it so the business could not reasonably calculate a quarterly payment.
- The taxpayer could not determine whether it will have a CAT liability in 2020.
- The taxpayer made a reasonable estimate based on information available at the time.
- The taxpayer relied on information that was contained in a proposed administrative rule.
Business & Occupation (B&O) Tax
The Washington Department of Revenue has offered favorable guidance for businesses that received federal financial assistance. Businesses that received any federal assistance (including the federal Paycheck Protection Program (PPP)) should not report the assistance as gross receipts for B&O tax purposes for now. However, this is not a final decision, and the Department of Revenue indicated that it would continue to analyze the various programs more thoroughly. It will issue a final decision once the Legislature has had an opportunity to act, so businesses should be mindful that this is not a final ruling.
Washington has not released any guidance regarding the “physical presence” threshold for its B&O tax. In Washington, a business must pay B&O tax if it (1) has physical presence nexus in Washington; (2) has more than $100,000 in combined gross receipts sourced to Washington; or (3) is organized or commercially domiciled in Washington. The Washington Administrative Code says that even the “slightest presence” of a single employee may trigger the physical presence nexus. Thus, a remote worker could trigger nexus and an additional filing requirement for a company even if they do not normally meet the $100,000 threshold.
California has at times either restricted the ability of individuals and corporations to utilize the full carryover amount of net operating losses (“NOLs”) or completely suspended net operating loss deductions for business entities and individuals with business income in response to facing budgetary constraints. For example, in response to the global mortgage crisis that began in 2008 and the severe recession that followed and triggered a state budget crisis, California suspended NOL deductions for years from 2008 through 2011.
CA Assembly Bill 85
With the COVID-19 pandemic an omnipresent influence on daily life, state governments are trying to recoup lost funds through tax law changes. As a result of the coronavirus pandemic, California has a projected budget deficit of around $54 billion. To mitigate the effects of lost general fund revenues and increased health and human services costs, on June 29, 2020, Governor Gavin Newsom signed into law Assembly Bill 85 (“AB 85”). Two of the main provisions of AB 85 mirror the state’s historical efforts to regain lost revenues by suspending NOL deductions and limiting business incentive tax credits. The projected revenues for these two provisions of AB 85 total $9.2 billion: $4.4 billion in 2020-2021, $3.3 billion in 2021-2022, and $1.5 billion in 2022-2023.
Suspension of Net Operating Loss Utilization
NOL usage for California taxpayers with net business income of $1 million or more will be suspended for tax years beginning on or after January 1, 2020 and before January 1, 2023. As with similar provisions previously enacted, the carryover period for suspended NOLs has been extended. For losses incurred in taxable years beginning on or after January 1, 2021, and before January 1, 2022, the carryover period has been extended one year. For losses incurred in taxable years beginning on or after January 1, 2020, and before January 1, 2021, the carryover period has been extended two years. For losses incurred in taxable years beginning before January 1, 2020, the carryover period has been extended three years. However, under Legal Ruling 2011-4, the California Franchise Tax Board (“FTB”) takes the position that unless a taxpayer could utilize at least $1 of NOL during a suspension year, the taxpayer is not entitled to the extended carryover periods.
Limitation of business incentive credits
AB 85 also limits the use of business incentive tax credits for taxable years 2020, 2021, and 2022 by requiring that credits not reduce the applicable tax by more than $5 million. This limitation is applied on a combined group basis. Similar to the suspended NOLs, credit carryforward periods have been extended by an additional year for each year the credit is impacted by the limitation. The limitation on the utilization of credits extends to the California research and development (“R&D”) credit, jobs tax credit, motion picture production credits, and California competes credit and impacts both corporate and personal income taxpayers. Certain credits, however, including the low-income housing tax credit and earned income tax credit, among others, are excluded from this limitation.
Implications and Tax Planning
As this assembly bill was passed prior to the close of calendar year entities’ quarter 2 close, it is necessary to evaluate the implications as part of any Q2 2020 filings and disclosures. Companies should consider whether or not it makes sense to implement tax planning strategies to increase taxable income in 2019 to utilize unrestricted NOLs and/or to reduce taxable income below $1 million for years 2020, 2021 and 2022 to the extent possible, such as, among many planning ideas, accelerating deductions, adopting accounting method changes, and making California 59(e) elections on 2019 tax returns to push deductions to years when the NOL is suspended. In addition, based on the methodology applied by the FTB under Legal Ruling 2011-8, depending on the value of the NOL available by year, under a cost versus benefit analysis, it may be advantageous for a taxpayer to increase taxable income above $1 million during one or more of the suspension years in order to obtain the additional carryover periods for certain prior year net operating loss carryforwards.
While this tax law change is inconvenient for many business entities, it is not a new method for states, particularly California, to employ to regain lost revenues. There is historical precedent for similar revenue generating measures instituted by California dating back many years. While COVID-19 continues to present ongoing business, economic, personnel, and planning challenges, ways to mitigate the impact of the California NOL suspension and the business incentive credit limitation should be highlighted and investigated.Read More
On July 16, 2020, the Portland Metro Council unanimously voted to send a $7 billion transportation plan to the November ballot. This tax will impose a payroll tax on employers for individuals who perform services in the Metro Area. The rate will not exceed 0.75% of wages paid by the employer, and employers with 25 or fewer total employees are exempt from paying the tax.
If the Metro area voters pass the payroll tax in the November election, it will commence at the beginning of 2022. The Metro Council amended the original proposal by exempting state and local governments from paying the tax due to the COVID-19 economic impact. The Metro Council still has not solidified its plan on how the payroll tax will be imposed on local businesses. In the initial draft plan, five of the seven council members advocated for an aggressive payroll tax approach, which would impose a 0.75% payroll tax on employers in the Portland metro area immediately. Other council members support a gradual increase in payroll tax with rates starting at 0.1% that would increase to 0.6% by 2028. In the coming months before the November election, the Portland Metro Council will release its more detailed plan.
Future Uncertainty and Implications
There is controversy surrounding the new payroll tax that will be imposed on Portland businesses. The Portland Business Alliance, along with other business groups in the metro area have expressed their concerns about the tax. Those groups have suggested that the Metro Council delay the referral measure to the ballot until a later date for businesses that are struggling due to the COVID-19 pandemic. Other areas in the Portland metro, like Clackamas County, do not benefit as much from the transportation plan, and the Clackamas County Commissioner has voiced his concerns about the measure. The new payroll tax also comes in the wake of the recently passed 1% tax on businesses to fund housing services for homeless people in the metro area that is slated to begin in 2021. This tax will cause further hardship to Portland businesses already facing multiple state and local taxes, including the Multnomah County Business Income Tax; Oregon Corporate Income/Excise Tax; Oregon CAT; City of Portland Business Income Tax; City of Portland Clean Energy Surcharge; and the City of Portland Pay Ratio Surcharge.
The question has arisen regarding how to account for loans received by companies under the Payroll Protection Program (“PPP”) of the CARES Act as there are no accounting standards specific to government assistance received in this form. In the absence of standards specific to a transaction, Accounting Standards Codification (“ASC”) 105-10-05 directs a company to look to accounting guidance for similar transactions, unless direct application or application by analogy to the transaction is specifically prohibited by that guidance.
Before determining which accounting guidance to apply to the PPP loan, a company should first assess whether they believe some or all of the loan will ultimately be forgiven. For calendar year-end financial statements, non-public companies may have the benefit of hindsight, as further clarifications are issued by the government, and companies begin applying for loan forgiveness.
If there is significant uncertainty as to whether the loan will be forgiven or not, the conservative position is to account for it as a traditional loan under ASC 470, as the initial form of the PPP loan is debt. Accounting for the loan as debt would result in a company recognizing the proceeds and gross debt obligation upon issuance, and an expense over the term of the loan for interest at the stated rate (there is no interest imputation where the government has set the rate). Accounting for the loan as debt results in a more delayed income statement impact if the loan is forgiven, as the company would recognize the resulting gain only upon the company’s actual release as the primary obligor on some or all of the loan balance. Further, consistent with debt accounting, the cash flows would be reflected in financing activities in the statement of cash flows. Similarly, a company could account for the PPP loan forgiveness as a gain contingency under ASC 450-30 with largely the same result.
Alternatively, a company can analogize to IFRS International Accounting Standard (“IAS”) 20 to account for the PPP loan. Under IAS 20, debt would only be recognized to the extent that the loan is not expected to be forgiven. Once there is reasonable assurance (similar in concept to probable under ASC 450) that the conditions for forgiveness will be met, including at loan issuance, it is effectively accounted for as grant income. As grant income, a company may record in the income statement either other income or a deduction (offset) to the related expense, in this case, the qualifying expenses incurred.
IAS 20 prescribes only that recognition of grant income should be on a systematic and rational basis over the period that the company incurs the related expenses related to the original loan. If the expenses have already been incurred, then the grant is recognized when the forgiveness is reasonably assured. Further, cash flow presentation for the PPP loan proceeds when analogizing to IAS 20 would be reflected in operating cash flows, based on the expenses to which they relate (payroll and other operating expenses).
A company can also analogize to ASC 958-605, which is normally applicable to not-for-profit entities, and would also treat the loan forgiveness as if it was grant income; however, as compared to IAS 20, it has a higher threshold for recognition of the loan forgiveness. While IAS 20 allows for recognition when it is reasonably assured, ASC 958-605 only permits a company to record when the conditions for forgiveness are substantially met. This indicates a higher hurdle than probable, which could mean that recognition would be later than under IAS 20. Further, presentation is more restrictive under ASC 958-605, where the credit is required to be presented gross, likely as other income, rather than allowing for an offset against the related expense.
It is noteworthy that if the PPP loan is accounted for as a government grant under either IAS 20 or ASC 958-605, subsequent to loan issuance, a company will need to continually reassess whether it expects to meet the criteria for loan forgiveness and adjust the grant income as necessary. If a company no longer expects to meet the criteria, it will likely need to reverse the previously recognized grant income.
Treasury Provides Welcome Grace Period and Transition Relief from Repeal of the “338 Approach” to Recognition of Built-in Gains (but the clock is ticking)
On January 14, 2020, the IRS and Treasury provided partial relief from their earlier announcement of the repeal of a highly favorable method of increasing the Section 382 limitation on the use of net operating losses and other tax attributes of a target by an acquiring company. Those rules have been a staple of the M&A tax toolkit for nearly 20 years. The new proposed regulations delay the applicability of the reversal and would provide transition relief to grandfather deals in certain circumstances.
As mergers & acquisition activities have come to a virtual standstill in the wake of the economic consequences of COVID-19, potential acquirers who expect to factor the value of tax attributes into their pricing once deal flow resumes must remember that the usual calculus will change dramatically unless certain steps are completed within 30 days after the final rules are published by the government.
Section 382 imposes a limitation on the ability of a “loss corporation” to offset taxable income with “pre-change losses” in periods after an “ownership change” takes place (i.e., after the “change date”). For purposes of section 382, an ownership change occurs if a loss corporation’s stock that is owned by its “five-percent shareholders” increases by more than fifty percentage points during a “testing period” which is generally the three years prior to the change date. If an ownership change occurs, section 382 limits the annual utilization of pre-change realized and net unrealized losses in an amount generally equal to the fair market value of the loss corporation’s stock immediately before the ownership change multiplied by the applicable long-term tax-exempt rate.
Special rules under section 382(h) apply for loss corporations that have net unrealized built-in gains (“NUBIG”) or losses (“NUBIL”) on the date of the ownership change which are recognized after the ownership change. For NUBIG companies that have “recognized built-in gains” (RBIGs), the IRS allows the loss corporation to increase its annual section 382 limitation during the five years following the ownership change date. Essentially, taxable income from built-in gains can be offset by pre-change losses without limitation. However, NUBIL companies that experience “recognized built-in losses” (RBILs) occurring during the recognition period are subjected to the section 382 limitation similar to existing net operating losses of the target as of the change date. The policy underlying these rules is that losses existing at the change date, whether realized or not, be permitted to offset unrealized gains existing at the change date without being subjected to the Section 382 limitation since such gains and losses both economically accrue prior to the ownership change.
The challenge for taxpayers desiring to maximize the benefit of pre-change losses is in identifying the recognition of a built-in gain during the recognition period. The actual sale of an appreciated plot of land is the easy academic example. But much more valuable assets are economically realized in much more subtle ways, especially for high technology or brand name companies. The intellectual property or goodwill of the target company is rarely recognized through sale. Rather, the “wasting” of such intangible assets is often the primary driver of post-acquisition operating profits. In this sense, a “slice” (and often an ample one) of these post change date profits is attributable to value that accrued prior to the acquisition and represents the recognition of a built-in gain.
For over a dozen years after Section 382 was promulgated in substantially its current form with the Tax Reform Act of 1986, taxpayers and the IRS were at odds over this concept of some component of post-change operating income being attributable to pre-change built-in gains that was eligible for offset by pre-change losses without restriction by the annual Section 382 limitation. Finally, in response, the IRS published Notice 2003-65 permitting taxpayers to rely on safe harbor approaches for applying the built-in gain or loss rules of Section 382(h) to an ownership change “prior to the effective date of temporary or final regulations.” That caveat proved to be an ominous one. Notice 2003-65 provided taxpayers with two alternative safe harbors, the 338 Approach and the 1374 Approach, for the identification of RBIGs and RBILs of the loss corporation.
The two approaches are similar in that both measure unrecognized built-in gains and losses at the change date based on deemed sales of all of the loss corporation’s assets. The 1374 Approach borrows the accrual method rules used to measure net recognized built-in gain for purposes of C corporations electing S status. The 338 Approach borrows similar rules which compare actual items of income, gain, deduction, and loss with those that would have resulted had a Section 338 election been made in a hypothetical purchase of all of the stock of the loss corporation on the change date.
The subtle but critical difference is the broader scope of built-in gain and income items under the 338 Approach which includes “forgone” depreciation and amortization deductions. In application, the Section 1374 Approach favors the deferral of NUBILs because it requires an actual discrete disposition event in order to apply. On the other hand, the 338 Approach is favorable for loss corporations in a NUBIG position because it accelerates RBIGs in the form of taxable income in amounts equal to the incremental amortization or depreciation that would have been available had a tax basis step-up to fair market value been provided at the change date.
In essence, such depreciation or amortization of the NUBIG under the applicable tax conventions for cost recovery is a surrogate for measuring the incremental income generated by the acquired assets. Prior to Notice 2003-65, taxpayers and the government had argued over more subjective economic analyses reminiscent of the litigation over the actual tax amortization of purchased goodwill that led to the enactment of Section 197 in 1993.
September Proposed Regulations
The proposed regulations eliminate the 338 Approach and make a modified version of the 1374 approach the lone safe harbor for RBIG and RBIL recognition. The headline effect is to eliminate the unlimited use of target company NOLs in an amount equal to one-third (i.e., 5 year recognition period relative to 15-year recovery period) of the appreciated value of the target company’s intangible assets unless an actual recognition event occurs. For an early stage high technology company such as a pre-commercial stage biotechnology enterprise, the regulations would result in an enormous discount on what would have been the value of their NOL and R&D tax credit attributes under the 338 Approach unless deals are structured differently than the typical stock acquisition.
The regulations make other modifications to the application of the 1374 Approach, particularly in the treatment of cancellation of indebtedness income and deductions for the payment of contingent liabilities. Those details are outside of the focus of this paper.
January Proposed Regulations
The proposed regulations issued in January, among other things, provide some relief for taxpayers against an abrupt change in rules just as a deal is closing. Prior to their issuance, a deal closing on the day after the regulations were issued and priced based on attributes available under the 338 Approach to harvesting tax attributes, would have suddenly been subjected to the harsher 1374 Approach. Instead, the January proposed regulations provide a grace period and a transition rule for deals in process when the September regulations go final.
The grace period is in the form of relief for ownership changes that occur up until the new final regulations are released plus an additional thirty days. In other words, once the regulations go final, taxpayers have 30 days to close the deal and avail themselves of the 338 Approach unless they qualify for the grandfathered scenarios provided below.
Under the grandfather rules afforded by the January proposed regulations, the final Section 382 regulations will not apply to an ownership change arising with an “owner shift” or “equity structure shift” that occurs:
- Pursuant to a binding agreement in effect on or before the delayed applicability date (i.e., the end of the 30-day grace period) and at all times thereafter;
- Pursuant to a specific transaction described in a public announcement made on or before the delayed applicability date;
- Pursuant to a specific transaction described in a filing with the Securities and Exchange Commission submitted on or before the delayed applicability date;
- By order of a court (or pursuant to a plan confirmed, or a sale approved, by order of a court) in a title 11 or similar case, provided that the taxpayer was a debtor in a case before such court on or before the delayed applicability date; or
- Pursuant to a transaction described in a private letter ruling request submitted to the IRS on or before the delayed applicability date.
Taxpayers can elect to apply the final regulations to ownership changes otherwise qualifying for this relief if they choose.
With the welcome transition relief granted by the January proposed regulations, acquirers are less susceptible to an abrupt change in the value of target attributes at the 11th hour of completing a transaction. Nonetheless, companies that are seeking to acquire loss corporations need to be agile, despite the currently bleak deal landscape, if they want to utilize the favorable 338 approach. Once the final regulations are issued, companies only have thirty days to take some action, if it has not already been taken, in order to apply Notice 2003-65. Although 30 days may not offer significant time to take an action sufficient to be grandfathered, these regulations seem to have taken a back seat to the TCJA regulations projects for the time being. Nonetheless, business development teams will want to monitor the Federal Register for the release of the final regulations and have plans to accelerate deal milestones to meet the transition relief.Read More
Companies Continue to Evaluate APB 23 Benefits After Tax Reform; Impact of COVID-19 Related Repatriations on the Indefinite Reinvestment Assertion
The general comprehensive rule for providing deferred taxes on book-tax basis differences under ASC 740-10 requires companies to record a deferred tax liability (DTL) for any GAAP outside basis in their foreign subsidiaries in excess of their tax basis. ASC 740-30-25-3 provides a rebuttable presumption that all offshore earnings contributing to the basis difference will be repatriated. For years, US multinationals have achieved significant effective tax rate benefits by avoiding an accrual of this DTL by invoking the exception to the presumption known as the indefinite reinvestment assertion as provided by ASC 740-30-25-18. The assertion requires companies to demonstrate their ability and intent through a documented plan for utilizing the excess earnings in the foreign jurisdictions while demonstrating those earning are not needed in the United States.
After the Tax Cuts and Jobs Act (TCJA), companies were subjected to a one-time transition tax under IRC Section 965 on all post-1986 undistributed foreign earnings and profits which had not already been subject to tax by the anti-deferral regime of Subpart F of the Internal Revenue Code (IRC) through one of two alternative dates at the end of 2017. This tax on all previously untaxed offshore earnings, coupled with other provisions of the TCJA which generally either subject all future offshore earnings to current taxation (e.g., “GILTI” under Section 951A) or permanently exempt them from taxation (e.g., IRC Section 245A), have required US-based multinationals to reevaluate their historic indefinite reinvestment assertion.
Why Continue to Assert Indefinite Reinvestment ?
On the surface, the indefinite reinvestment assertion might seem to be a relic of accounting history. Why seek a deferral of taxes on earnings that are either currently taxed or fully excluded from taxation? However, there are still consequences of not being permanently reinvested. Differences in outside basis still arise and the 100% dividend-received-deduction (DRD) under IRC Section 245A does not always allow them to be settled without tax consequences. For example, purchase accounting can create book-tax basis differences. Underlying differences between GAAP income and GILTI “net tested income” can also produce basis differences. The Section 245A DRD does not apply to capital gains such that basis differences not settled through a repatriation of earnings can have tax consequences. The states have not all conformed to the TCJA changes such that the settlement of basis differences could result in state taxes requiring a DTL.
Further, the TCJA does not change the potential need for DTLs on basis differences between non-U.S. entities in the organizational structure of a U.S.-based multinational enterprise. APB 23 must be evaluated for each legal entity whose operations are included within the group’s financial statements. Most U.S-headquartered multinationals have formed intermediate foreign holding companies. Taxpayers must examine what taxes are required in the jurisdiction distributing the cash (i.e., withholding taxes) and what income (i.e., dividends) is included in taxable income in the jurisdiction receiving the cash. If taxable by the receiving jurisdiction, there is a further need to analyze whether mitigation of any resulting double taxation is available through mechanisms such as foreign tax credits (FTCs). Maneuvering through relief afforded by participation exemption regimes and the further impact of each country’s tax treaty is complex.
Regardless of any book-tax basis differences at the various levels within a structure, there are other tax consequences of repatriating foreign earnings. For example, a U.S. company that revokes its indefinite investment assertion could also be subject to withholding taxes which would need to be accrued. In addition, foreign currency gains and losses on the withholding tax and any offsetting FTCs would have to be accrued and booked through the income statement since they constitute transaction gains and losses on a non-functional currency obligation of the U.S. shareholder. ASC 830 requires recognition of such gains and losses in earnings since the withholding tax is a foreign-currency denominated monetary obligation.
Further, IRC Section 986 imposes a tax on foreign exchange rate gains or losses on previously taxed earnings and profits (PTEP) which must be accrued in advance of an actual distribution. Since these are translation gains and losses, the tax accrual would be booked through the cumulative translation account.
The amounts involved may not be material but the administrative burden of keeping track of all of this alone could be sufficient to convince companies to make no change to their current assertion in the aftermath of the change in tax law. Others may decide to make a partial reinvestment assertion, which is expressly permitted, and repatriate some earnings due to the diminished financial accounting consequences of doing so. Some companies will revoke their indefinite reinvestment assertion entirely because the flexibility in the movement of global cash outweighs the administrative burdens described above. A scan of the tax footnotes of 10-Ks issued by public companies since the passage of the TCJA does not reveal a consistent pattern of the legislation’s impact on the assertion of indefinite reinvestment other than to observe that gone are the days when conventional wisdom dictated that most companies made it.
APB 23 Indefinite Reversal Assertion and Coronavirus Cash Needs
As is the case with many aspects of income tax accounting, consistency is the key to the indefinite reinvestment assertion under ASC 740-30. The appropriate facts and circumstances can justify a departure whereby offshore earnings are repatriated. An infrequent distribution of foreign earnings caused by an unforeseen event should not per se belie a company’s past and future assertion regarding its intent and ability to reinvest its foreign earnings.
In order to justify a continuing indefinite reinvestment assertion after such a departure, a company should consider the change in conditions that resulted in the repatriation, and the likelihood that this change could occur again. A pattern of “one-time” exceptions to permanent reinvestment will clearly call the assertion into question since the exception has become the rule and the normative presumption of repatriation much harder to rebut.
The global economic downturn caused by the COVID-19 pandemic has created a liquidity need for many U.S. companies that is often disproportionately concentrated in their domestic operations. When senior management addresses the overriding imperative of these liquidity needs by accessing foreign cash, financial management must evaluate whether these actions are an exception justified by what are clearly unprecedented circumstances or if there is a “new normal” that undermines further permanent investment assertions.
Once the economic consequences of the pandemic subside, companies who wish to maintain the indefinite reinvestment assertion going forward, notwithstanding having accessed foreign cash during the crisis, will need to consider:
- Reestablishing the baseline of cash needs and uses by jurisdiction in the new normal that emerges, including how the pandemic is impacting their business lines by geography, and where it is causing the most significant cash shortages.
- Critically challenging prior assumptions that were key to a particular company’s assertion such as the balance between domestic and foreign acquisition pipelines which may have been altered by the differential economic impact of the pandemic on likely targets.
- Permanent supply chain disruptions and the potential for onshoring operations to mitigate the risk of foreign supply chain dependencies.
- Evaluating the impact of the downturn on previous CapEx plans by jurisdiction.
- Establishing contingency plans should a “second wave” or more onsets of the virus ensue and evaluating their funding implications.
- Evaluating whether debt covenants and interest rates have been modified as a result of the economic downturn, impacting the relative cost of borrowing and altering ready access to that source of funding by region.
- Identifying any new US or foreign regulations that were enacted in the aftermath of the pandemic and evaluating whether they change relative trade volumes through such measures as tariffs or restrict intercompany cash transactions through tighter restrictions such as exchange controls.
- Reassessing their transfer pricing policies regarding which costs should be borne by which entities.
- Reviewing tax holiday agreements which require specific investments in capital improvements or headcount to maintain the holiday
- Facing the prospect of whether it is time to simply acknowledge that the economic calculus of accessing foreign cash instead of traditional domestic sources has been permanently altered by the TCJA.
Despite a generally unsettled state, what is becoming clear is that the unprecedented economic impact of the COVID-19 pandemic, coming on the heels of a once-in-a-generation U.S. tax law change, presents an environment where longstanding bedrocks of income tax accounting such as APB 23 must undergo a comprehensive re-evaluation. The underlying accounting standards have not changed, but the environment in which they must be applied is radically altered from what it was just three years ago.Read More
IRS Issues Flexible Guidance on QIP, bonus depreciation and other favorable elections under CARES Act
On April 17, 2020, the IRS released Revenue Procedure 2020-25 (the “Rev Proc”), which provides guidance to enable taxpayers to accelerate their cost recovery of qualified improvement property (QIP). This guidance comes in response to Congress’ enactment of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which includes a technical correction to the recovery period for QIP from 39 years to 15 years. This reclassification also makes QIP eligible for bonus depreciation under the general depreciation system (GDS) which is currently 100% of the cost through 2022, ratcheted down by 20% per year through 2026. The guidance provides additional unexpected flexibility for taxpayers in exercising hindsight to optimize cash flow and liquidity under the CARES Act.
Qualified Improvement Property
QIP includes any improvement made by the taxpayer to the interior of nonresidential real property. The improvement must be placed in service after the building was first placed in service. Improvements do not qualify if they relate to the internal structural framework of the building, an elevator or escalator, or an enlargement to the building. QIP should have been granted a 15-year recovery period under GDS (or 20-year under ADS, the alternative depreciation system) and been eligible for bonus depreciation since 2017. However, a drafting error in the Tax Cuts and Jobs Act (TCJA), known as the “retail glitch,” did not include QIP in the list of 15-year property, making it ineligible for bonus depreciation. The CARES Act retroactively corrected the error allowing taxpayers to elect to treat QIP placed in service after Dec. 31, 2017 as 15-year property that is eligible for bonus depreciation. Pursuant to the Rev. Proc. a taxpayer can elect to correct its cost recovery of QIP for prior years by (1) attaching Form 3115 (Application for Change in Accounting Method) to a federal income tax return, or (2) filing an amended federal income tax return or an Administrative Adjustment Request (AAR).
Change in Accounting Method
The first option available to the taxpayer is to change its accounting method for QIP. The Rev. Proc. allows taxpayers to file Form 3115 to make an automatic change to their accounting method even if cost recovery for the QIP was only claimed once on a previous tax return (an accounting method is usually established only after two consecutive returns are filed). The Form must be timely filed with the original Federal income tax return or Form 1065 for either the taxpayer’s first or second taxable year after the taxable year in which the taxpayer placed the QIP in service, or, if later, that is timely filed between April 17, 2020, and October 15, 2021.
For example, in the case of QIP placed in service in 2018, if the 2019 tax return has not yet been filed, the correction to 100% bonus expensing could be made either on a Form 3115 filed with the 2019 return or by amending the 2018 return. If the 2019 tax return has already been filed, the 2018 benefit could be claimed on a Form 3115 filed with the 2020 tax return or by amending both the 2018 and 2019 returns.
Amended Return or Administrative Adjustment Request
The second option for taxpayers is to amend their previous returns that classified QIP as 39-year property. The Rev. Proc. specifically allows partnerships to amend their return even if it would normally be required to file an AAR pursuant to the special audit rules of the Balanced Budget Act of 2015. When amending a return or filing an AAR, the taxpayer must include the adjustment to taxable income caused by the change in QIP and any other ancillary changes to taxable income. Additionally, if any returns have already been filed for the tax years subsequent to the year that is being amended, such returns must be amended as well for any collateral adjustments. The amended return or AAR must be filed before October 15, 2021 (but not after the applicable period of limitations on assessment).
Other Elections for Bonus Depreciation and ADS
The new 15-year recovery for QIP could adversely affect some taxpayers based on individual circumstances, including interactions with the limited window for the 5-year carryback of NOLs and the increased deductibility of interest expense under Section 163(j) under the CARES Act. Anticipating such circumstances, the Rev. Proc. also provides taxpayers increased flexibility to reevaluate and make or revoke depreciation elections they made or did not make in prior years, including elections under Sec. 168(k)(5), (7), (10), and (g)(7).
Similar to the amended return requirements for the QIP election, the amended return or the AAR filed to make one of these late elections or revocations must include the adjustment to taxable income as well as any collateral adjustments to taxable income or tax liability. Also, all late elections and revocations must be made on or before October 15, 2021.
Tax Planning Implications
The flexibility offered by Rev. Proc. 2020-25 provides numerous opportunities for taxpayers. Taxpayers that have made significant QIP expenditures since 2017, and are in a taxpaying position, should take advantage of the change to immediately convert tax liabilities into cash. Specifically, C Corporations should evaluate their tax positions to see if claiming bonus depreciation on QIP could create or increase a net operating loss (NOL) in years from 2018-2020 that can now be carried back up to five years under the CARES Act to years in which the top corporate tax rate was 35%. The CARES Act also allows NOLs generated during those years to offset 100% of taxable income in that same period, potentially making this election even more favorable for C Corporations. Finally, taxpayers should reevaluate their previous depreciation elections to see if the 20/20 hindsight afforded by the Rev. Proc. provides an immediate path to more cash in the door which is what the CARES Act is all about.