ASC 740: Q1 2022 Provision Considerations

Earlier this month marked two years since the World Health Organization declared a global pandemic. Since then, businesses have had to continually adapt to stay afloat while taking measures to ensure safety for employees and customers. While parts of the business cycle return to normal with efforts to bring office employees back to the office, new concerns about rising inflation and continued supply chain issues, made worse by the war in Ukraine, require businesses to adapt once more. Meanwhile, Congress has created further headwinds for businesses by failing to finalize tax law reforms, including those that have broad bipartisan support, such as the delay of required capitalization of research and experimental expenditures. Therefore, while companies continue to wait on Congress to act, companies with interim financial statements must now consider the law as enacted. The following update provides insights on federal and international tax laws that may impact a company’s first quarter provision in 2022. Read more about state and local tax considerations in our companion alert: State tax law changes for the first quarter of 2022.

Section 174 Required Capitalization Now Effective

Calendar year companies are now required to capitalize certain research and experimental expenditures under section 174. The capitalization requirement, included as part of the Tax Cuts and Jobs Act (TCJA), is effective for tax years beginning after Dec. 31, 2021. Section 174 requires that companies capitalize and amortize domestic research and experimental expenditures over five years and foreign expenditures over 15 years. In addition to requiring capitalization, the TCJA also codified that self-developed software costs are now section 174 expenditures. Prior to the TJCA, the IRS had indicated in Rev. Proc. 2000-50 that such costs so closely resembled research and experimental costs to warrant similar treatment but had not specifically required companies to treat such costs section 174 costs.

For many public companies that are required to use the effective tax rate approach under ASC 740-270 to account for income taxes in interim periods, the new temporary difference resulting from required capitalization under section 174 will have little to no impact on the company's quarterly income tax expense, to the extent the Company is able to recognize the benefit of its deferred tax assets.

However, certain companies, particularly those with significant R&D expenses (e.g., companies in the life sciences and technology industries) may have large current year unfavorable adjustments that may have other impacts on the company's provision. For example, an entity that has historically been a loss company and has provided a valuation allowance on its deferred tax assets may now be in a position where the section 174 addback results in the utilization of NOL carryforwards. This fact pattern may often result in a company recording a deferred tax asset for future section 174 deductions and utilizing an NOL carryforward, largely substituting one deferred tax asset for the other on the balance sheet. However, if most of the company's NOL carryforwards were generated post-TCJA and are only able to offset taxable income up to 80%, the limitation on the NOLs may result in a current cash tax liability. Such entities would be required to recognize the current federal tax liability and likely would not be able to benefit the future DTA created by the amortization, due to the need for a valuation allowance. This fact pattern could be further complicated when a company has discrete items recorded in the quarter that would reduce the amount of current tax liability, such as excess tax benefits from a stock compensation windfall.

Additionally, companies with Controlled Foreign Corporations (CFCs) with foreign section 174 expenditures may have increased tested income, resulting in an increased global intangible low-taxed income (GILTI) inclusion for 2022 without a corresponding foreign tax. Companies accounting for GILTI inclusions as a period item, as opposed to a deferred basis, may have increased forecasted annual effective tax rates as a result of required capitalization.

Complicating this analysis is the reality that the anticipated deferral of required capitalization resulted in the IRS issuing little new guidance on what companies are required to capitalize under section 174. Companies will likely have to make estimates and carefully analyze the facts and circumstances of research and experimental expenditures to determine the impact in the first quarter, including carefully considering contracts with foreign subsidiaries that are performing research on behalf of a US parent company. These estimates may need to be revised later in 2022 if the IRS issues regulations impacting the company’s analysis of costs required to be capitalized.

Even if companies ultimately expect required section 174 capitalization to be deferred before any 2022 tax returns are filed, as was the goal of Congress as part of the stalled Build Back Better Act, it is critical that companies understand and estimate the impacts based on the enacted law as of the date of the financials, as required under ASC 740.

While non-public companies have additional time to consider the potential impact of section 174, ultimately, section 174 may not be deferred or repealed prior to the end of the calendar year, meaning that such companies would also have to reflect section 174 in year-end financial statements. Additionally, all corporations will need to consider section 174 when determining any estimated payments, as outlined in RSM’s alert: R&E capitalization may mean higher 2022 estimated tax payments.

Interest Expense Limitation

Another of the provisions included in the Tax Cuts and Jobs Act with a delayed effective date was a change to the definition of Adjusted Taxable Income (ATI) in determining the limitation on deductible interest expense under section 163(j). For years beginning on or after Jan. 1, 2022, the determination of ATI no longer includes an addback for depreciation, amortization, or depletion. Companies should consider the change in definition of ATI in calculating their estimated current tax liability for the first quarter of 2022, if necessary. Any scheduling exercises for supporting the amount of interest carryforwards more-likely-than-not to be realized must also reflect the appropriate amount of ATI.

Foreign Tax Credit Regulations

In January, the IRS issued final regulations addressing various foreign tax credit issues. The final regulations make several modifications to the proposed regulations issued in November of 2020. The final regulations provide additional guidance on allocating foreign taxes and circumstances under which a foreign tax credit may be denied under section 245A. Additionally, the final regulations include a jurisdictional nexus requirement for determining whether a foreign tax may qualify as an income tax for purposes of section 901. Companies should carefully consider the impact of the final regulations on foreign taxes and reflect any necessary adjustments in the quarter.

Updates from the Financial Accounting Standards Board (FASB)

FASB issued two accounting standards updates during the first three months of the 2022. The first related to accounting for derivatives and hedging instruments and the second related to troubled debt restructurings and vintage disclosures.

The Board recently met and discussed the proposed accounting standards update for enhancements to income tax disclosures. The FASB decided to revise the project scope and objective. Going forward, the Board’s objective for the project will focus on improving the transparency and decision usefulness of income tax disclosures and such improvements will focus on income taxes paid and the rate reconciliation.

State and Local Update

The Multistate Tax Commission (MTC) issued guidance in August of 2021 that provides specific examples of internet activities that are or are not deemed to be doing business in a state. The guidance could result in significant state tax liabilities going forward for companies that sell tangible personal property online. Throughout 2022, as states begin adopting this guidance, companies will need to assess whether their activities are still protected under P.L. 86-272, if new state filings are required going forward, or if a reserve for unrecognized tax benefits is required as a result of a decision to not file a tax return. California was the first state to issue guidance that addresses the guidance from the MTC. Read more about California’s guidance and about other important state and local tax law changes in the alert: State tax law changes for the first quarter of 2022.

International Tax

Australia

The 2022-23 Federal Budget has been brought forward from the usual timing of the second Tuesday in May to March 29, 2022. This is because Australia’s next Federal Election must be held by Saturday, May 21, 2022. While there are not any enacted tax law changes as of the end of the first quarter of 2022, the budget and election may result in future changes to tax policy for companies with activities in Australia.

Germany

While not a change in the first quarter of 2022, following a German Federal Fiscal Court in May of last year, there has been increased focus in Germany on profit shifting through intercompany loans. The German Federal Fiscal Court (BFH ruling dated May 18, 2021 I R 4/17) has ruled that the arm's length nature of the agreed interest rate for an intercompany loan must primarily be determined by comparing the agreed interest rate with the interest rate that would have been agreed, for example, for comparable bank loans (price comparison method). This also applies to unsecured intercompany loans. The assessment of the risk is not based on the average creditworthiness of the Group as a whole, but on the creditworthiness of the Group company taking out the loan ("stand-alone" rating). Only when such a price comparison is not possible the so-called cost-plus method can be used, in which the lender's cost is calculated and increased by an appropriate profit mark-up. This method, which is often used by the tax authorities, regularly leads to lower comparative interest rates.

Hong Kong

On Feb. 23, 2022, the Financial Secretary delivered the 2022/23 Budget Speech at the Legislative Council.  The budget proposed the following major relief and measures:

• A one-off reduction by 100% of profits tax for 2021-22, subject to a ceiling of HK$10,000
• Providing a reduced tax rate concession to maritime enterprises
• Introducing a domestic minimum top up tax for multinational enterprise groups with a global turnover of at least 750 million euros from 2024-25 to ensure alignment with the OECD’s proposed 15% minimum tax.

Ireland

Compliance Intervention Framework

The Irish Revenue unveiled its new Compliance Intervention Framework which will have a significant impact on all taxpayers. The new Framework has introduced new factors such as real-time reporting, an increase of tax transparency and the use of a dedicated digital resource by Revenue. The new Framework is effective from May 1, 2022 and is a further evolution to non-compliance. The Framework should be considered in the context of the self-assessment regime and is based on the principle that it is the responsibility of the taxpayers to ensure their returns are accurate and filed on time.

The Framework is updated to include 3 intervention levels which support self-review and self-reporting of tax errors. Level 1 is designed to support and remind taxpayers of their obligations without the need for a more in-depth review. Level 2 has two types of interventions: audits, and risk reviews. Level 3 takes the form of an investigation and occur when Revenue below there has been serious tax/duty fraud or evasion.

The risk review under Level 2 is a new concept. It will focus on a particular issue in the tax return, or a risk identified from Revenue. A risk review will commence 28 days after the date of notification. A taxpayer can still make a prompted qualifying disclosure in respect of tax underpayments up to the commencement of the risk review.

The other keys changes from the updated Framework are:

• To self-correct without penalty, the taxpayer must first notify the Irish Revenue in writing.
• Taxpayers now have 28 days to prepare for an audit
• The deadline to submit a notice of intention to prepare a prompted disclosure has been increased to 21 days
• There will be no publication of taxpayers who have underpaid or incorrectly received a refund of less than €50,000

Wind Down of Covid-19 Supports

On Dec. 21, 2021, the Irish Government announced an extension of the Debt Warehousing scheme which applies to businesses already eligible for warehousing who continue to avail of Covid supports. For those in receipt of the Employment Wage Subsidy Scheme (“EWSS”), the extension applies if an employer is already availing of the Debt Warehouse scheme and receives at least one valid paid claim during the period from 1 Jan. 1, 2022 to April 30, 2022 in respect of a pay date in that period. The extension applies to the Period 1 end date for all taxes which have been warehoused, which now has an end date of April 30, 2022.

Italy

The Italian Government repealed the former “patent box regime” by replacing it with an additional 110% super deduction for R&D expenses incurred in relation to copyrighted software, industrial patents, designs and models. Trademarks, legally protectable processes, formulas and industrial, commercial or scientific know-how, previously included in the regime, are now out of the scope of the application of the new patent box regime. More specifically, starting from financial year 2021 Italian taxpayers may opt for a five-year period in which the additional 110% super deduction will be applicable for corporate income tax purposes (i.e., IRES and IRAP). The option is elected in the tax return and it is irrevocable and renewable. The Tax Authorities specified that the expenses related to R&D that can be stepped up by 110% are those incurred for workers, assets depreciation, consultancy fees, services and materials. Taxpayers may apply for penalty protection, in case of a tax assessment, by preparing a defined set of documentation and communicating its existence in the relevant tax return.

Mexico

In late December of 2021, the approved Mexican tax reform was published at the official gazette, this reform was set in force Jan. 1, 2022. Some of the relevant tax reform measures are as follows:

• Maquiladoras are no longer allowed to determine tax profit under an advance pricing agreement (APA). Going forward, taxpayers must use the safe harbor method to meet Mexican transfer pricing requirements.
• Mandatory statutory audit of financial statements and tax returns for entities with revenues higher than about 1,600 million pesos.
• A business purpose will be required to obtain tax benefits related to a sale of shares at tax cost, tax deferred group restructuring, and tax-free mergers and spin-offs.
• All Mexican legal entities, trusts, profit-or cost-sharing agreement, or any other entity formed under Mexican legislation, are required to maintain as part of accounting books several support documentations that fully identify the ultimate beneficial controller.   
• Intercompany loans lacking a business purpose will be considered as a back-to-back loan. Interest on back-to-back loans is treated as a deemed dividend for tax purposes.

For additional considerations regarding the Mexican tax reform, see the alert: An overview of Mexican tax reform in 2022.

Netherlands

The Netherlands introduced legislation at the end of 2021, which are now final and will be effective as of Jan. 1, 2022.

The top corporate income tax in the Netherlands is now 25.8%, while the lower rate continues to be 15%. The first bracket for the lower tax rate was increased and now applies to profits of up to €395,000 (in 2021 the first income bracket was up to €245,000).

Loss relief

Additionally, the legislation includes new tax loss utilization rules that result in an indefinite loss carry-forward period as of Jan. 1, 2022. However, losses can only be fully deducted (on an annual basis) up to an amount of €1 million plus 50% of the taxable profit that exceeds €1 million.

For example, a company with a deductible loss of €3 million and a profit in the following year of €4 million, would be able to offset €2.5 million of with prior year losses (i.e., €1 million and 50% of the remaining €3 million). Corporate income tax is payable on the remaining €1.5 million. The background to the proposed scheme is that larger profitable companies always pay corporate income tax in years of profit. The new scheme also contains transitional law. For the carry forward of losses, losses incurred in financial years that started on or after Jan. 1, 2013, fall under the new scheme that comes into effect on Jan. 1, 2022. The State Secretary promised to adopt a policy of approval for the situation in which the concurrence of the so-called compensatory tax levy test of the measures limiting the interest deduction and the amended loss set-off regime, turns out to be unreasonable.

Introduction of tax liability measure for reverse hybrids

As of 2022, reverse hybrid entities (transparent according to Dutch law but non-transparent according to foreign law) will be liable to Dutch corporate income tax. This measure stems from the EU ATAD2 Directive. Furthermore, the concept of affiliation is to be extended to natural persons. The reverse-hybrid rule is likely to affect Dutch transparent CV's (i.e., limited partnerships) used in a CV-BV structure, where the CV is considered to be transparent for Dutch tax purposes and related non-resident participants are located in a jurisdiction that view the CV as non-transparent (e.g., under the US check-the-box regime).

Preventing mismatches when applying the arm's length principle

The so-called ‘arm's length principle’ aims to ensure a market-conform distribution of profits within groups. Since not every country applies this principle (in the same manner), this can lead to a part of the profits of a multinational company not being taxed. This type of mismatches is now being addressed. In short, the measure entails that no 'minus' can be claimed for tax purposes in the Netherlands if there is no corresponding 'plus' abroad.

Earnings stripping

The earning stripping measure will also be tightened, effective from Jan. 1, 2022, by limiting the interest deduction to 20% of the EBITDA for tax purposes, down from the current 30%. For now, the €1 million threshold will not be affected.

Mandatory sequence for the set-off of foreign profit tax levied on CFCs

Additionally, in situations where a controlled foreign company (CFC) is subject to a profit tax, the set-off of such tax is limited to the actual amount of Dutch corporate income tax due. In case of several CFCs, a certain set-off sequence is used, which is now also laid down by law: the smallest amount of foreign profit tax is to be settled first. The profit tax that remains unsettled in a year, can still be settled in later years.

Loophole in loss compensation rule for holding and financing losses closed

Holding and financing losses can no longer be set off against operating profits as the nature of the subsidiary's activities are to be taken into account in certain circumstances. In June 2021, the Dutch Supreme Court ruled in favor of a taxpayer who set off operating profits against holding and financing losses by the use of a fiscal unity for corporate income tax purposes. In principle, holding company and financing losses must not be set off against operating profits. However, based on the combined application of the fiscal unity and the holding and financing losses rules the set-off of these two types of losses became possible by the use of fiscal unity. This loophole is now closed as of Jan. 1, 2022.

Temporal limit with regard to set-off of dividend withholding tax and gambling tax with corporate income tax

The set-off of dividend withholding tax and gambling tax against corporate income tax will be limited up to the amount of corporate income tax due before the set-off. Taxes that cannot be set off in a year are carried forward to future years without time limitations. Also, the term within which the Tax Inspector can adopt a (revised) decision regarding withholding taxes to be carried forward, is extended from five to 12 years in the event of an additional claim from corporate income tax on foreign profits. These changes are implemented as of Jan. 1, 2022.

Environmental Investment deduction

There are three categories within the Environmental Investment deduction, each having a specific percentage for a deduction. These percentages will be increased from 13.5%, 27%, and 36% to 27%, 36%, and 45%. This results in a maximum net benefit of 14%. The highest percentage is applied to investments in assets that contribute most to the priorities set in the relevant policy, such as a circular economy and electrification. These changes will be implemented as of Jan. 1, 2022.