No year-end tax package leaves businesses with unfavorable changes

Businesses must contend with several unfavorable tax changes now that Congress is considering a year-end omnibus package that does not address many key tax issues—specifically, the tax treatment of research and development expenses (Internal Revenue Code section 174), calculations used to determine limitations on the deductibility of business interest expenses (section 163(j)), and bonus depreciation. And with a divided Congress set to be seated in January, significant tax legislation seems unlikely during the next two years.

In this edition of Tax Policy Now, members of RSM US LLP’s tax policy team explain the political dynamics and what actions businesses should take now to account for the unfavorable changes.

Below is a transcript of the discussion between Dave Kautter, RSM federal specialty tax leader and former assistant secretary of the Treasury; Justin Silva, regional leader of RSM’s credits, incentives and methods practice; Matt Talcoff, RSM Washington National Tax leader; and Dan Ginsburg, RSM public affairs leader. The conversation has been edited for clarity and length.

Dan Ginsburg: Despite months of Congress hinting about a lame-duck tax package, including a fix to the section 174 R&D tax amortization issue and the new section 163(j) calculation for determining business expense deductions, it looks like the Grinch has made his way to Capitol Hill. Dave, what happened?

Dave Kautter: I think what happened was an inability to compromise on the part of Republicans and Democrats on Capitol Hill.

The Democrats refused to support any changes to the business tax provisions unless they got changes to the child tax credit. Republicans wanted changes to the three business tax provisions—the R&D expensing, capital expensing (bonus depreciation), and 163(j) changes on interest expense.

Democrats weren’t willing to agree to those unless the Republicans agreed to changes on the child tax credit. Costs of the child tax credit changes were too high, they couldn't reach agreement, and so there's no deal.

The one thing they did agree on is to incorporate some retirement provisions—the so-called SECURE Act 2.0—and pay for that with changes to the conservation easement law. Other than that, no agreements.

Dan: Yeah, so it looks like nothing is happening this year. What about prospects for 2023?

Dave: The only thing that changes in 2023 is the Republicans gain control of the House. The costs of the child tax credit and the three business provisions are exactly the same.

The demands on both sides of the aisle are exactly the same. And it's hard to imagine that unless one side blinks, which at this point appears unlikely, we will get any meaningful tax legislation in 2023 or 2024. Again, anything is possible. But right now, it doesn't look promising.

Dan: Interesting perspective. Justin, I know you've been talking a lot with clients about R&D, and this has been an issue we've been talking about for many months. But now how has this conversation shifted?

Justin: Absent any type of legislative fix, at a bare minimum, anybody with a tax provision—your SEC filers and your C corporations—is, at least for financial statement purposes, going to have to reflect the change to capitalizing R&D in their income tax provision.

The level of documentation required is probably dependent on materiality and some auditor judgments, but because income tax provisions usually have accelerated timelines relative to the rest of the financial statements, this is an immediate action item.

Dan: It seems like a pretty significant challenge. As a taxpayer, what should I be doing right now?

Justin: Yeah, it's certainly a challenge. To the extent you have not already done so, you have to undertake some type of estimation exercise as soon as possible. That usually involves understanding where your R&D costs are—both in the United States or overseas and on your trial balance. It depends where your impacted areas are.

There's a lot of uncertainty right now on technical positions. Where will you have to position your company, let's say, if you have indirect costs or cost-sharing agreements or you have to allocate certain types of costs to your R&D cost center? And then what type of documentation are your auditors going to expect to support that estimate? Is that just a file documentation? Is that a provision memo, or is that something more like a full-on tax opinion memo, depending on the risk or impacted area?

Dan: If I don't have a tax provision, though, should I still be thinking about this?

Justin: You definitely have to be thinking about it. We have three big factors at play. The first is what Dave just talked about: Can Congress actually change this, or will they? That looks very unlikely now, so we need to use the law that's in effect.

The second is: Will Treasury or the IRS issue some type of definitional guidance so that we actually know specifically what is section 174, what is R&D, and what is the government expecting to see from us?

The third item, we just received last week, and that's effectively transitional guidance that allows taxpayers to file automatic accounting method changes to reflect this.

So regardless of whether you're a C corporation or flow-through entity, the time for inaction has really come and passed at this point. You need to at least start estimating or scoping, if not preparing, for a full-on change to this new tax provision.

Dan: Now, Matt, another business tax provision not included was 163(j) and the shift from calculating interest deductions using EBIT (earnings before interest and taxes) rather than EBITDA (earnings before interest, taxes, depreciation and amortization). What are the implications?

Matt Talcoff: We've been speaking about this for most of the year, and it's a very important provision. It's law right now. We had a switch from what was known as an EBITDA-like calculation for the limitation on business interest to an EBIT calculation. It means, especially for those capital-intensive businesses that have a lot of depreciation and amortization, it’s a significantly more restrictive provision.

It's in place now. We were hoping for a change. Certainly, a lot of manufacturers hoped that there would be a change, but it doesn't look like there's any change soon, so businesses need to continue to prepare their filings under the current provisions.

They should be prepared to model things out if things do change sometime next year, which, again, is very uncertain. And certainly prepare the cash flow impacts once they file extensions or returns, presumably in March or April.

Dan: Got it. More broadly, taking into account all the things we’ve discussed, what's the message you're giving clients right now?

Matt: The message is: Continue modeling and be prepared with your cash flow.

We spoke throughout this year about a few different provisions: the R&D provision, which has a major impact; interest limitations; and even the bonus depreciation provision—there will be a change where you no longer get 100% bonus depreciation. We need to continue to watch that.

Certainly, different industries are impacted differently. Life science businesses and technology, media, and telecom companies could be majorly affected by some of the R&D provisions that Justin spoke about. They’ll need to even challenge some of the lost carryforwards they had if they had equity changes in prior years.

I think everybody needs to be prepared with their filings. Is it a decision to extend? Will you file a substitute return? Will you amend a return? All those things will be conversation topics as we move into 2023.