Executive summary: Q3 2023 provision considerations
As the third quarter ends, the phrase “higher for longer” reverberated through the business community after the Federal Reserve noted after not raising rates in September, rates were likely to remain higher for longer. While higher rates mean companies will continue to face higher borrowing costs, the Fed decision also signals a lower probability of a recession. Read more about current economic conditions in this quarters Middle Market Business Index. Globally, the tax landscape continues to evolve as countries enact tax legislation relating to the OECD’s Pillar Two initiative that includes a global minimum tax framework. State legislatures continue to update conformity dates, reduce tax rates, and address nexus methodologies. The following update provides insight on federal, state, and international tax laws and an update on the income tax disclosure requirements proposed by the Financial Accounting Standards Board.
Income tax provision considerations for the third quarter of 2023
Foreign Tax Credits
Multinational taxpayers will need to evaluate the effect on the company’s income tax provision of temporary relief granted by the IRS regarding the calculation of foreign tax credits. In July, the IRS has granted relief to taxpayers in Notice 2023-55 in determining whether a foreign tax is eligible for a foreign tax credit under sections 901 and 903. Many taxpayers had raised concerns after the 2022 final regulations were published that foreign taxes that were previously creditable would no longer qualify for a credit. The temporary relief allows taxpayers to largely apply the former version of the regulations in place as of Apr. 1, 2021. The relief is available for tax years beginning on or after Dec. 28, 2021, and ending on or before Dec. 31, 2023. This relief is likely to result in the ability for a company to claim additional foreign tax credits, particularly related to foreign withholding taxes and certain foreign income taxes that may have not totally conformed with the U.S. tax system. The IRS has also indicated that they are likely to extend this relief through 2024. Any changes in a Company’s 2022 tax provision related to this notice should be reflected as a discrete item in the Company’s third quarter tax provision, while the impacts for 2023 would be reflected in the 2023 effective tax rate. Read more about the relief granted in the alert: Temporary relief granted for the foreign tax credit.
Corporate Alternative Minimum Tax (CAMT)
The IRS issued Notice 2023-64 which provides interim guidance for taxpayers to apply until proposed regulations are issued. The notice provides additional guidance on several of the reconciling adjustments from financial statement income to income subject to the CAMT, including depreciation, qualified wireless spectrum and certain duplications and omissions. The notice also provides guidance on financial statement net operating losses (FSNOL) and CAMT foreign tax credits, and the determination of an entity’s applicable corporation status.
The IRS has also released a draft of Form 4626 Alternative Minimum Tax – Corporations which provides some insight into calculating the CAMT liability, however, instructions for this form have not yet been released. Notice 2023-64 indicates that any forthcoming proposed regulations would apply to taxable years beginning on or after Jan. 1, 2024, permitting taxpayers to rely on guidance in the notices issued over the last year for 2023 tax years and until proposed regulations are issued.
Required capitalization of research or experimental expenditures
The IRS released Notice 2023-63 regarding required capitalization of specified research or experimental (SRE) expenditures under section 174 that was first effective for tax years beginning after Dec. 31, 2021. Notice 2023-63 describes costs that are includible in SRE expenditures, costs excludible from SRE expenditures, activities considered software development and how to recover the SRE expenditures. The guidance comes as most taxpayers have either filed or are finalizing their 2022 tax returns, the first returns reflecting required capitalization. Forthcoming proposed regulations will apply to taxable years ending after Sept. 8, 2023; however, taxpayers may choose to rely on the guidance in the notice provided they rely on all the rules and apply them in a consistent manner. If a company chooses to apply the guidance in the Notice to 2022 and such application results in a change to the amount of SRE expenditures capitalized, that change should be reflected in the third quarter. Read more about the specifics of the notice in the alert: IRS releases initial rules for expenditures under section 174.
Changes in estimate
The fast-approaching corporate tax return deadline for extended calendar year returns also means it is time to revisit any changes in estimate from the related provision. Under ASC 250-10-45-17, changes in estimates, are accounted for prospectively in the period of change. As companies finalize their calculation of taxable income for return purposes, return-to-provision adjustments should be reflected in the period they are known. While companies may have identified return-to-provision adjustments that are appropriate to include in the third quarter as discrete adjustments, there may be other effects of individual adjustments, such as impacts on interest expense limitations and state taxes, that may support waiting until the fourth quarter to record these changes in estimate.
Updates from the Financial Accounting Standards Board (FASB)
The FASB issued three accounting standards updates (ASU) during the third quarter of the year, including ASU 2023-03: Presentation of Financial Statements (Topic 205), Income Statement-Reporting Comprehensive Income (Topic 220) Distinguishing Liabilities from Equity (Topic 480), Equity (Topic 505, and Compensation-Stock Compensation (Topic 718) addressing various SEC updates, ASU 2023-04: Liabilities (Topic 405) addressing amendments to the SEC Staff Accounting Bulletin No. 121 and ASU 2023-05: Business Combinations-Joint Venture Formations (Subtopic 805-60) addressing recognition and initial measurement.
Earlier in 2023, the FASB issued a proposed ASU outlining changes to income tax disclosure requirements for all business entities. The main provisions of the proposed ASU include further disaggregation of the rate reconciliation and income taxes paid disclosures. During the third quarter, the FASB met to deliberate and vote on changes to the proposed ASU regarding expanded income tax disclosures. The Board’s deliberations and directives for finalizing the ASU largely follow the guidance provided in the proposed ASU as outlined in our prior external article: ASC 740: FASB proposes new income tax disclosures. The final ASU is expected to include additional clarity on various questions raised via feedback from stakeholders and modify certain requirements in the proposed ASU.
The final ASU is expected to clarify that while all items in the rate reconciliation should generally not be netted against other items, the final ASU will allow entities to disclose the effects of certain cross-border tax law items on a net, rather than a gross basis. For example, the final ASU is expected to permit entities to disclose the effects of global intangible low tax income (GILTI) net of the related foreign tax credits.
In a move that is expected to be broadly welcomed by financial statement preparers, the FASB decided to permit entities to present changes in unrecognized tax benefits on an aggregate basis from all jurisdictions as one line in the rate reconciliation rather than requiring the unrecognized tax benefits category to be reported by individual jurisdiction to the extent they were more than the 5% disaggregation threshold.
The FASB decided to eliminate a proposed interim disclosure requirement for a separate qualitative analysis of reconciling items that result in significant changes in the estimated annual effective tax rate from the effective tax rate of the prior annual reporting period.
As part of the final ASU, entities are expected to receive some clarity on other requirements around the rate reconciliation disclosures including certain qualitative disclosures, such as the requirement to disclose the state and local jurisdictions that contribute to the majority of the effect of the state and local income tax category. The FASB clarified that “majority of the effect” means greater than 50% of the effect of the category.
The FASB affirmed its decision that income taxes paid will be required to be disaggregated by federal, state, and foreign categories. Within each category, additional disaggregation will be required for individual jurisdictions that comprise 5% or more of total income taxes paid (net of refunds). However, the FASB decided that this disclosure will only be required for annual reporting periods, eliminating the requirement to disclose disaggregation by federal, state and foreign, on an interim basis.
The Final ASU will be effective for public business entities with fiscal years beginning after Dec. 15, 2024, and interim periods within fiscal years beginning after Dec. 15, 2025, and will be applied on a prospective basis. The Final ASU is expected to be effective for entities other than public business entities with fiscal years beginning after Dec. 15, 2025, and interim periods within fiscal years beginning after Dec. 15, 2026. The Board decided that all entities should apply the amendments on a prospective basis, but entities may elect to apply the amendments on a retrospective basis. Early adoption will be permitted. The FASB staff are drafting the final ASU for the Board to vote on.
State tax
There were several significant state tax law changes in the third quarter of 2023, including changes to tax rates, apportionment methodologies and updates to conformity with the Internal Revenue Code. Read more about state and local tax considerations in our companion alert: State tax law changes for the third quarter of 2023.
International Tax
Pillar Two
Pillar Two aims to enact a global minimum corporate tax of 15% of adjusted net income on large international businesses regardless of the locations of the business’ headquarters or jurisdictions in which the business operates. Many countries have announced support for the Pillar Two initiative and as of Sept. 30, 2023, approximately 22 countries have come forward with proposed legislative changes to adopt the objectives of Pillar Two. It is important to note that only legislation enacted as of the balance sheet date is applicable for an income tax provision under GAAP and while many countries are in the process of enacting legislation, possibly during the fourth quarter of 2023, the FASB indicated earlier this year that taxes under Pillar Two would be viewed as similar to an alternative minimum tax as discussed in Topic 740, Income Taxes. Under ASC 740, deferred taxes would not be recognized or adjusted for the future effects of the minimum taxes. Ultimately, companies will need to evaluate the laws that are enacted and reflect any effects on the income tax provision in the period in which the legislation is enacted.
During Q3, the OECD released administrative guidance that included a transitional safe harbor rules for the adoption of Pillar Two. This guidance applies to tax years that begin on or before Dec. 31, 2025, and end before Dec. 31, 2026. For additional information on the safe harbor guidance, read RSM’s tax alert: Transitional Pillar Two safe harbor.
Brazil
During the second quarter of 2023, Brazil published Law No. 14,596/23 which changes the Brazilian transfer pricing legislation to align with OECD guidelines. Final regulations were published on Sept. 29, 2023 and the new rules will become mandatory in 2024, with companies have the option to apply the rules in 2023 as long as they make a decision to do so by Dec. 31, 2023. One goal of the new transfer pricing legislation was to comply with rules for the recognition of foreign tax credits in the United States since the disparity in the transfer pricing legislation of the two countries represented an obstacle to qualifying for a foreign tax credit.
The Provisional Measure No. 1.185/23, aims to modify the regulation related to tax credits resulting from ICMS (State Value-Added Tax) subsidies, which were considered exempt from tax income. It was published by the Federal Government on Aug. 30, 203. The modification includes the taxation of the subsidies amount that must be related to the implementation and expansion of the economic enterprise and a tax credit system with requires a prior authorization to be used against tax debts. The new rules establish that investment subsidies will be taxed and will generate a tax credit based on IRPJ (corporate income tax) paid over these revenues that can be offset with other taxes. This matter is subject to approval by National Congress.
Bill No. 4258/23, related to the end of tax benefit related to interest on net equity (INE) paid to shareholders, was sent by the Federal Government to the Chamber of the Deputies’ voting. The Government intends to eliminate the deductibility of INE as from January 2024 aiming to increase tax collection.
Chile
An income tax treaty between the United States and Chile received Senate approval earlier this year. Once the treaty has entered into force, the treaty will offer reduced withholding taxes and result in certain Chilean income taxes becoming eligible for foreign tax credits. More information regarding the treaty can be found in the article: United States and Chile income tax treaty moves forward.
Germany
On Aug. 30, 2023, the German Federal Government approved the draft of a Growth Opportunities Act, which intends to counteract the economic burdens of the multiple crises for the German economy and to increase its growth opportunities. At the same time, it includes counter-financing measures. Read more about the intended changes to the corporate income tax in the article: Government draft of a Growth Opportunities Act.
The incorporation of the Pillar Two objectives into German tax law is progressing. Following the presentation of the first draft of the planned regulations earlier this year, the German Federal Government adopted the draft. This draft also contains other amendments to existing tax laws related to the new minimum tax law. Read more about Germany’s adoption of Pillar Two in the article: Federal Cabinet approves Draft for Implementation of the Global Minimum Tax.
Ireland
Ireland’s Knowledge Development Box (KDB) is an intellectual property (IP) regime, which provides relief from corporate tax on income arising from qualifying assets such as computer programs, inventions protected by a qualifying patent or certified inventions for small and medium sized companies.
The KDB was originally introduced for companies whose accounting periods commence on or after Jan. 1, 2016, and provided that a company which qualifies for the regime will be entitled to a deduction equal to 50% of its qualifying profits in computing the profits of its specified trade. Accordingly, the profits arising from patents, copyrighted software or IP equivalent to a patentable invention are taxed at an effective rate of 6.25%.
Irelands KDB will be impacted by the Pillar Two Subject to Tax Rule (STTR), which allows for the levying of additional tax on certain connected party payments when such payments are not subject to an adjusted nominal tax rate of at least 9% in the country of residence of the recipient. Accordingly, as part of the 2022 Finance Act, and subject to a Ministerial Commencement Order a proposed update was to be made to the KDB regime whereby there would be an increase in the effective tax rate of the KDB from 6.25% to 10%. The commencement order was signed on Sept. 5, 2023, and the increase in the effective tax rate for the KDB will take effect from Oct. 1, 2023.
Netherlands
In November 2022, the Dutch State Secretary of Finance published a new decree on the interpretation of the Dutch anti-hybrid rules, known as the Anti-Tax Avoidance Directive II (ATAD2). The decree addressed specific adverse situations resulting from the Dutch implementation of ATAD2, which impacts specific U.S. multinational enterprise (MNE) groups with cost-plus structures including companies in the Netherlands. Read more about the impacts of the ATAD2 rules in the alert: The Netherlands: Impact of ATAD2 to U.S. multinationals.
United Kingdom
Finance (No. 2) Act 2023 received royal assent on July 11, 2023, and includes measures such as the introduction of the Pillar Two income inclusion rule, a domestic minimum top-up tax, changes to research and development (R&D) tax reliefs, and 100% relief in the year of acquisition for certain capital expenditures until April 2026.
Draft legislation in respect of further changes to the UK tax code was published later in July. The proposals include:
- Further reforms to the UK’s enhanced R&D tax reliefs with effect from April 1, 2024, which would see all other than certain smaller knowledge intensive companies claiming relief by way of an ‘above the line’ tax credit (i.e., a credit recognized for accounting purposes as an item of profit before tax) mechanism, and restrictions on the circumstances in which relief can be claimed for non-UK expenditure;
- An overhaul of creative sector enhanced tax reliefs, including a move to an ‘above the line’ credit for film, television and video games reliefs from April 1, 2024; and
- The introduction of the Pillar Two undertaxed profits rule with effect for accounting periods beginning on or after Dec. 31, 2024.
Separately, the UK tax authority has updated its technical guidance on the corporation tax implications of net-settled and cash canceled employee share option schemes. Employers that operate such schemes may wish to review the treatment applied in corporation tax returns to ensure that the filing position adopted is robust and defensible.
