With 2020 in the rearview mirror, it is time to take a look back at the events of the year and consider recent accounting guidance, new tax laws and regulations, and the effects of COVID-19 and the ways they might impact a company’s provision for income tax.
In response to the economic concerns caused by the COVID-19 pandemic, Congress passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act in late March. The CARES Act temporarily increased the amount of deductible interest under section 163(j) from 30% to 50% for tax years beginning in 2019 or 2020, allows companies a five year carryback of certain net operating losses (NOLs), and temporarily suspends the 80% limitation on the utilization of NOLs for tax years beginning before Jan. 1, 2021. The CARES Act also made two technical corrections to NOLs related to the 2017 legislation, the Tax Cuts and Jobs Act (TCJA), fixing an issue with the applicability dates for fiscal years and clarifying that the appropriate calculation of the 80% limitation on the utilization of NOLs where a company is utilizing both pre-TCJA and post-TCJA NOLs is to first reduce taxable income by the unlimited pre-TCJA NOL and then calculate the 80% limitation on the remainder.
In addition to the above changes to NOLs and section 163(j) limitations, the CARES Act modifies two other provisions of the TCJA, accelerating the period in which Alternative Minimum Tax credits are fully refundable and providing a technical correction for qualified improvement property to allow this property to qualify for bonus depreciation. This change is retroactive to the date of the enactment for the TCJA.
As companies prepare their year-end provision, they will need to analyze the effect of any potential loss carrybacks, which may impact credits and deductions claimed in prior years, such as AMT and R&D credits, GILTI and the domestic production activities deduction (DPAD) in years prior to the TCJA. Additionally, due to the timing of the CARES Act, companies may have substantial adjustments from the prior year provision for depreciation, section 163(j) limitations and NOL carryforwards, which could impact the valuation allowance analysis as discussed below.
The CARES Act also created the employee retention credit, a payroll tax credit for up to 50% of $10,000 in eligible employee wages. For financial statement purposes, this credit should be recorded as a reduction of payroll tax expense. Accordingly, the credit is considered in the determination of pretax book income and no further adjustment is required when determining taxable income for provision purposes. Although the actual credit is not included in taxable income for tax purposes (so that a taxpayer deducts the full amount of payroll taxes), depending on the type of credit the actual credit must be added back to taxable income, or an amount of wages equal to the amount of the credit must be added back to taxable income. The result is that there is no book-tax difference.
Read more about the provisions of the CARES Act and additional related accounting for income tax considerations in the alert from March: Accounting for the tax provisions of the CARES Act.
Paycheck Protection Program loans
In recent weeks, Congress reached an agreement on additional aid and passed the Consolidated Appropriations Act, 2021 (the CAA), which was signed into law on Dec. 27, 2020. The CAA provides for an additional round of PPP loans and grants companies a tax deduction for expenses paid with the proceeds from PPP loans. Under previous law, while the proceeds from PPP loan forgiveness were not taxable, the loan forgiveness would result in the loss of deductions for expenses paid from the loan proceeds. The new law ensures that income from the forgiveness of PPP loans remains exempt from federal tax, while companies can now deduct the related expenses.
Prior to the passage of the CAA, companies may have had a timing difference for income tax provision purposes related to PPP loans as a result of the difference between book and tax treatment of the expenses when loan forgiveness occurred and was recorded after the period in which expenses were incurred. For financial reporting expenses, those amounts would have been expensed, while for tax purposes any deduction would be deferred unless it was anticipated that the loan would not be forgiven. The temporary difference would reverse in the subsequent period when the loan forgiveness was included in financial statement income. With the enactment of the CCA, companies no longer have a temporary difference related to the deductibility of expenses and would record a permanent adjustment for the amount of financial statement income recognized as a result of the loan forgiveness.
The shift to expenses being deductible is a change in tax law (and not a clarification of existing tax law) and accordingly, should be reflected in a company’s tax provision in the period of enactment (i.e., the period including Dec. 27, 2020). Therefore, a fiscal year company with a financial statement period ending before Dec. 27, 2020, should record a temporary item for PPP expenses when there is a timing difference in accordance with the tax law in effect at that time. The company would then reflect the tax benefit of the deduction of the expenses in the provision for the period including Dec. 27, 2020.
Consider the following example for Company XYZ with a fiscal year-end of Sept. 30, 2020:
Company XYZ applied for and received a $500,000 loan under the Paycheck Protection Program. In the financial statement period ended Sept. 30, 2020, the Company reflects the PPP loan on their books as a liability under the guidance in ASC 470. During the same period, the Company incurred $500,000 in eligible expenses paid from the proceeds of the loan. The Company anticipates that it will meet the requirements to have the loan forgiven and intends to seek forgiveness of the loan, however for financial reporting purposes the company has determined that no income should be recognized until the loan is actually forgiven. Under the relevant tax law as of Sept. 30, 2020, the Company has determined that the expenses should be treated as non-deductible in the period the expenses were incurred and for provision purposes will add back the expenses. Accordingly, in the provision for the period ended Sept. 30, 2020, the company records an unfavorable temporary adjustment of $500,000, resulting in a gross deferred tax asset of $500,000 as of Sept. 30, 2020.
Ultimately, on the tax return for the period ending Sept. 30, 2020, the Company would deduct the eligible expenses in accordance with the CAA. Therefore, in the period ending Sept. 30, 2021, the company would record an adjustment reversing the $500,000 of deferred tax asset in accordance with the requirement under ASC 740 that this benefit be recorded in the period of enactment. Assuming loan forgiveness was achieved, the Company would also have a favorable permanent adjustment to reverse the book income recognized upon forgiveness.
Companies should consider disclosing the expected impact of the change in tax law as a subsequent event to the extent that such impact is material.
Other changes in the Consolidated Appropriations Act, 2021
In addition to the changes made to the PPP loans, the Consolidated Appropriations Act, 2021, which was signed into law on Dec. 27, 2020, includes various other changes that are summarized in: Congress passes appropriations bill, containing COVID-19 relief bill. These other changes include enhancements to various credits, target relief to various industries, and a temporary increase in the deductibility of business meals from 50% to 100% for expenses paid or incurred in 2021 or 2022.
New guidance on intellectual property registered in Germany
In November, the German Ministry of Finance issued new guidance on the taxation of intellectual property registered in Germany. The new guidance indicates that the mere registration of intellectual property in Germany can create nexus and result in a withholding tax liability on any royalty or capital gain income generated by the intellectual property. The German tax authority could assess tax for periods up to 13 years ago. The effect of the guidance could be minimized for companies residing in a double tax treaty country. However, if the company has not filed a valid exemption certificate, the Company may have to make withholding payments and file for a refund. Companies should evaluate their compliance with the regulations to determine whether they need to record an unrecognized tax benefit reserve related to this issue.
For a more in depth look at the guidance and its implications, see the alert: New German guidance on withholding tax arising from IP transactions.
Section 163(j) regulations
In July, the IRS released final regulations regarding the business interest expense limitation under section 163(j). The regulations provide significant clarifications on the calculation of the limitation and several taxpayer friendly changes, including allowing companies to add back depreciation expense allocated to cost of goods sold to calculate adjusted taxable income. Companies can retroactively apply the final regulations to prior years.
Due to the unfavorable impact of the proposed regulations, many companies took a tax position that did not conform to the language of the proposed regulations, specifically with regard to the addback to depreciation, depletion and amortization deductions. While the proposed regulations were not binding on taxpayers, due to the weight given to the regulations companies may have recorded a reserve for unrecognized tax benefits, as the tax position may not have met the more-likely-than-not threshold required under ASC 740 to recognize the tax benefit of the tax position.
Many companies may have filed tax returns conforming to the final regulations during the recent filing season. With the changes in the final regulations, companies that added back depreciation, depletion and amortization deductions capitalized to inventory under section 263A, and are adopting the final regulations retroactively, can now recognize the tax benefit associated with this tax position in their tax provisions, releasing any unrecognized tax benefit reserves. For many companies, the changes under the final regulations for depreciation will simply result in a reclassification between the company’s income tax payable and deferred tax asset. However, for companies with valuation allowances, there may be additional impacts.
GILTI, FDII regulations
In mid-July, the IRS released a series of proposed and final regulations regarding foreign sourced income, including final regulations on global intangible low-taxed income (GILTI) and foreign derived intangible income (FDII) and new proposed regulations regarding subpart F income. On July 9, 2020, the IRS released a package of final regulations covering the computation of the section 250 deduction for purposes of GILTI and FDII. The regulations made minor modifications to the proposed regulations, mostly relaxing certain documentation requirements related to claiming the FDII deduction.
On July 20, 2020, the IRS finalized regulations related to the high-tax exclusion for GILTI. The final regulations are effective for tax years of foreign corporations beginning on or after July 23, 2020. For calendar year corporations, this would generally be 2021; however, taxpayers may apply the regulations retroactively to tax years of foreign corporations beginning after Dec. 31, 2017
Companies should evaluate whether they would benefit from the GILTI high-tax exclusion and include the tax benefits for current and prior years in their year-end provision. This analysis can be complex, so companies should consult with their tax advisors about the potential benefit of such an election.
Valuation allowance considerations
The economic realities of the COVID-19 pandemic will no doubt lead to more companies recording a valuation allowance against deferred tax assets due to the potential size of current year losses resulting in historically profitable companies now being in a three year cumulative loss position. To determine the appropriate amount of valuation allowance companies must evaluate the four sources of taxable income outlined in ASC 740:
- The future reversal of existing temporary differences;
- Future taxable income exclusive of reversing temporary differences and carryforwards;
- Taxable income in prior carryback year(s) if carryback is permitted under the tax law; and
- Tax planning strategies.
Since the passage of the Tax Cuts and Jobs Act, there has been an increased focus on the need to schedule the reversals of existing temporary differences due to the limitations on the utilization of interest and NOL carryforwards. In scheduling out these reversals, companies must also consider the ways that the above changes in tax laws will impact their analysis. Considerations include:
- Larger deferred tax liabilities related to fixed assets resulting from additional tax depreciation on qualified improvement property in the current and prior years as a result of changes under the CARES Act.
- The effect of the 163(j) final regulations, combined with increasing the limitation from 30% to 50% for tax years beginning in 2019 and 2020, could result in smaller section 163(j) carryforwards, however, companies should be attentive to where the increased interest deductions simply results in additional NOL carryforwards.
- While the CARES Act suspended the 80% limitation on the utilization of post-TCJA NOLs for tax years beginning before Jan. 1, 2021, the 80% limitation still applies to the utilization of post-TCJA NOLs in future years. Therefore, when looking at the reversal of existing temporary differences for Dec. 31, 2020 year-end provisions, companies should still apply the 80% limitation for post-TCJA NOLs.
- The utilization of NOLs via carryback may result in the carryforward of tax credits previously utilized in years where the company is now utilizing NOLs.
Updates from the Financial Accounting Standards Board
It has been over a year since the Financial Accounting Standards Board released ASU 2019-12 Simplifying the accounting for income taxes. ASU 2019-12 includes eight simplifications to ASC 740 which are outlined in the alert: ASU 2019-12 Simplifying the accounting for income taxes. For public business entities, the guidance is effective for fiscal years, and the related interim periods, beginning after Dec. 15, 2020. Companies should evaluate the expected impact of the standard and include language in their financial statements disclosing the anticipated adoption of ASU 2019-12. For non-public entities, the guidance is effective for fiscal years beginning after Dec. 15, 2021, and interim periods within fiscal years beginning after Dec. 15, 2022.
From the CARES Act, to tax regulation packages providing additional guidance on the TCJA, 2020 has been a busy year, especially as companies respond and adapt to the COVID-19 pandemic. Companies will need to consider the potential additional current year and retrospective benefits of the GILTI high tax exclusion, the enhanced depreciation deductions for qualified improvement property, the favorable final regulations and increased limitation under section 163(j) and temporary changes to NOL rules. Companies will also need to consider how each of these changes impacts their deferred tax assets and liabilities and any required valuation allowance.