Executive summary: Year-end ASC 740 Considerations
Heading into the end of 2022, there were a few items on taxpayers’ wish lists that Congress ultimately was unable to deliver, including the repeal or delay of required capitalization of research and experimental expenditures. While Congress did not enact significant corporate tax legislation in the final weeks of the year, the IRS and Treasury were busy releasing guidance on various issues, including section 174, the corporate alternative minimum tax, and the excise tax on stock buybacks. The following update provides highlights and insights on these issues and other federal, state and local and international tax laws that may impact a company’s 2022 provision as well as a few forward-looking considerations as the global tax landscape continues to change.
Required capitalization of research and experimental expenditures
The capitalization requirement under section 174, 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 (R&E) expenditures over five years and foreign expenditures over 15 years. While a delay or repeal of required capitalization was on the year-end wish list for many taxpayers, Congress did not address required capitalization prior to year-end. Accordingly, income tax provisions for calendar year 2022 financial statements will need to reflect the capitalization of R&E expenditures as the enacted law. Read more about the issues under section 174 and what to consider now in RSM’s tax alert: Looming required capitalization of section 174 expenditures: What do I need to do now?.
While required capitalization is generally a temporary difference, the capitalization of R&E expenditures can have indirect effects on a company’s income tax provision. Companies will need to carefully consider the impact of foreign R&E on any global intangible low-tax income (GILTI) inclusion. Additionally, companies that require a valuation allowance and have historically incurred taxable losses will need to carefully consider the interaction between the capitalization on current taxable income, the utilization of net operating losses and the company’s ability to realize its deferred tax assets.
On Dec. 12, 2022, the IRS released Rev. Proc. 2023-8 outlining guidance on automatic method change procedures to implement the capitalization and amortization rules under new section 174. Rev. Proc. 2023-8 provides a simplified filing process for taxpayers applying new section 174 methods for the first taxable year beginning after Dec. 31, 2021. Read more about the procedures outlined in Rev. Proc. 2023-8 in RSM’s tax alert: IRS issues method change procedures for sec. 174 R&E expenditures.
On Dec. 29, 2022, the IRS issued Rev. Proc. 2023-11 which modifies and supersedes the guidance in Rev. Proc. 2023-8. The updated guidance revises the audit protection rules included in Rev. Proc. 2023-8 to indicate that taxpayers that do not change their method to comply with section 174 in the first applicable year but rather change their accounting method in the year immediately subsequent to the first applicable year will not receive audit protection for expenditures paid or incurred in taxable years beginning after Dec. 31, 2021.
Inflation Reduction Act
President Biden signed the Inflation Reduction Act (IRA) into law on Aug. 16, 2022. The IRA includes a corporate alternative minimum tax (CAMT) that applies to certain applicable corporations with average financial statement income in excess of $1 billion and U.S. corporations with foreign parents that have over $1 billion in financial statement income, that have at least $100 million in financial statement income. The IRS and Treasury issued Notice 2023-7 on Dec. 27, 2022, providing interim guidance in advance of forthcoming proposed regulations. The notice addresses certain time-sensitive issues, however, there are a substantial number of questions remaining regarding the calculation of the book minimum tax. Read more in RSM’s tax alert: Treasury and IRS release interim guidance on corporate minimum tax.
The CAMT first applies to tax years beginning in 2023, so while companies may not have to file a tax return reflecting the minimum tax for a while, companies preparing year-end tax financial statements need to begin evaluating the impacts of the CAMT as guidance is released, including considering financial statement disclosure of the expected impacts if material to the company’s financial statements.
Another tax related item included in the Inflation Reduction Act is a new tax on publicly traded corporations that repurchase their stock, applicable to buybacks occurring on or after Jan. 1, 2023. The tax on share repurchases is not an income tax accounted for under ASC 740 but likely accounted for in equity as part of the cost of repurchasing stock. In advance of the tax’s effective date, the IRS and Treasury provided preliminary guidance in Notice 2023-2. The notice provides guidance on key questions regarding the applicability of the tax to certain transactions, the determination of the fair market value of the repurchased stock and the reporting of the tax. Read more in RSM’s tax alert: The IRS issues guidance on new 1% stock buyback excise tax.
The IRA also included various clean energy incentives included in the bill, which you can read more about in RSM’s alert: Clean fuel incentives in the Inflation Reduction Act of 2022.
Limitations on interest expense under section 163(j)
For years beginning on or after Jan. 1, 2022, adjusted taxable income (ATI) no longer includes an addback for depreciation, amortization, or depletion. Restoring the addbacks for depreciation, amortization, and depletion was another item on the year-end wish list of many taxpayers that Congress did not address before year-end. Companies will need to reflect the change in ATI and determination of the lamination on interest expense in year-end provision calculations.
Tax law changes applicable to 2023
As we begin a new year companies should also be aware of changes in tax law that are effective for 2023. Under the Consolidated Appropriations Act, 2021 companies were allowed a deduction for 100% of the cost of food and beverages provided by a restaurant in 2021 or 2022. The full deduction of these costs was provided by Congress to support the revitalization of the restaurant industry post-pandemic. For expenditures incurred after Dec. 31, 2022, food and beverages provided by a restaurant will no longer be 100% deductible and will revert to the general limitations on meals. Additionally, in general, the applicable percentage for bonus depreciation deductions available under section 168(k) for property placed in service after Dec. 31, 2022, will be reduced to 80%.
Updates from the Financial Accounting Standards Board (FASB)
FASB issued two accounting standards updates (ASU) during the fourth quarter of 2022 related to areas other than income taxes and issued six ASUs in total during 2022.
In November of 2022, FASB revised a long-standing agenda item that proposed significant expansion of required income tax disclosures. The targeted improvements include proposals to require additional information around cash taxes paid by jurisdiction and additional information around the rate reconciliation, including additional detail on the impacts of various jurisdictions on the rate. The board has agreed to the additional proposed income tax disclosures, with a proposed ASU in the drafting process. The targeted improvements will impact both private and public companies. The proposed ASU is expected in the first quarter of 2023.
Earlier in 2022, the Board issued a proposal that would expand the applicability of the proportional amortization method available to companies that invest in certain tax credit structures. Previously, the proportional amortization method was only available to investments in Low-Income Housing Tax Credit structures. The proposed guidance would allow companies to use the proportional amortization method to account for investments in other tax credit programs provided certain criteria outlined in the guidance are met. The Board has received comments on the proposal and is in the process of finalizing guidance.
Throughout 2022, states were busy enacting changes to tax laws, including a number of changes in state tax rates for 2022 and future years. Read more about the state tax law changes enacted during the fourth quarter in our companion alert: State income tax law changes for the fourth quarter of 2022. For information on state ASC 740 developments from prior quarters, please see our separate alerts from the first, second and third quarters of 2022, and download our comprehensive 2022 state and local tax year-end guide.
During the third quarter, the Australian Commissioner of Taxation released a Taxation Determination in relation to the interaction of Australia’s hybrid mismatch rules and the US GILTI rules. In the Commissioner’s opinion, income taxed in the US under the GILTI provisions is not dual inclusion income and therefore has no effect on whether a deduction/non-inclusion outcome arises under Australia’s hybrid mismatch rules. Read more about the potential impacts of this legislation in RSM’s alert: The potential impact of Australia's imported hybrid mismatch rules.
There are several legislative proposals in Australia that companies should be aware of that may be enacted in the near future, with the following proposals expected to apply from July 1, 2023.
Changes to Australia’s Thin Capitalization rules were announced in the Australian Federal Budget handed down in October. Currently three tests exist under Australia’s Thin Capitalization Rules – the safe harbor test, the arm’s length debt test, and the worldwide gearing ratio test. The safe harbor and worldwide gearing tests will be replaced with an earnings based test, under which an entity’s debt deductions will be limited to 30% of EBITDA. An alternative test will allow an entity in a group to claim debt deductions up to the level of the worldwide group’s net interest expense as a share of earnings, which may be more than 30% of EBITDA. The arm’s length debt test will be retained but will only apply to third party debt (it will not be able to be used to claim deductions on related party debt).
An anti-avoidance rule will be introduced to prevent Significant Global Entities (entities with global revenue of greater than A$1 billion) from claiming a tax deduction on payments made to related parties in low- or no-tax jurisdictions.
The Australian Government will increase reporting requirements to enhance public disclosure. The Government will require:
- significant global entities to disclose their tax information on a country-by-country basis and a statement on their approach to tax to be disclosed to the Australian Taxation Office
- Australian public companies to disclose information on the number of subsidiaries and their country of domicile; and
- tenderers for Australian Government contracts worth more than A$200,000 to disclose their ultimate head company’s country of domicile.
On Nov. 3, 2022, the Department of Finance released an updated package of the draft excessive interest and financing expense limitation (EIFEL) legislation. The EIFEL rules limit a taxpayer’s interest and financing deduction to a fixed ratio of earnings before interest, taxes, depreciation and amortization (EBITDA), referred to as adjusted taxable income. The ratio will be 40% for taxpayers with a taxation year beginning on or after Oct. 1, 2023 and before Jan. 1, 2024. This ratio will reduce to 30% for taxation years beginning on or after Jan. 1, 2024. While not yet enacted, companies should begin considering the impact of these rules. Read more about the considerations in RSM Canada’s alert: Economic statement 2022.
The Ministry of Finance in China issued Announcement on Increasing Efforts for Pre-tax Deduction to Support Scientific and Technological Innovation which allows for high-tech enterprises to deduct the full amount of equipment and appliances newly purchased during the period from Oct. 1, 2022 to Dec. 31, 2022 from the taxable income amount on a one-off basis in the current year. Additionally, for enterprises entitled to the current weighted pre-tax deduction ratio of 75% for research and development expenses, such ratio is raised to 100% during the period from Oct. 1, 2022 to Dec. 31, 2022.
In 2021, France enacted legislation to reduce the corporate income tax rate to 25%. The rate reduction was intended to boost the competitiveness of French companies, align French tax rates with those of other European countries, and avoid profit evasion. The tax rates in France for 2022 are as follows:
- Profits up to 500,000 Euros: 25%
- Profits over 500,000 Euros: 25%
- Qualifying Small-Medium Companies with turnover less than 10M Euros: 15% on the first 42,500 Euros
Extraterritorial taxation of IP registered in Germany for the most part abolished
Within the “Annual Tax Law 2022”, adopted Dec. 16, 2022, the German Government implemented their long-awaited revision of the so-called German Register Cases (see RSM’s alert from 2020: New German guidance on withholding tax arising from IP transactions). In the past two years there has been uncertainty amongst licensors and licensees of Germany-registered intellectual property (IP) and an international discomfort on Germany’s approach of taxing extra-territorial cases. As a reminder, the German Tax Authorities took the position that German tax was due on payments for the use or transfer of IP rights (e.g., patents) if those are directly entered in a German register or registered in Germany based on an application to the European Patent and Trade Office. As Germany does not grant benefits from its numerous Double Taxation Treaties (DTT) without applying for an exemption certificate in advance, but only provides reimbursements of tax withheld on application, the Tax Authorities have been flooded with applications, filings and ultimately appeals.
The new law, which is retroactively applicable in all open cases, abolishes this taxation for most cases. A tax nexus however shall remain in cases where:
- the payee is resident in a so-called tax haven, or
- the contracting parties are related and a DTT is not in place or not applicable due to the rather strict German Anti-Treaty-Shopping rule.
Taxation of equity repayments by foreign companies to German residents
Also, within the “Annual Tax Law 2022” a new rule for equity repayments received from non-EU corporations to German residents, applicable for repayments after Dec. 31, 2022, has been enacted. Equity repayments received by German resident persons generally lead to taxable dividend income. The new rule only allows for a non-taxable equity repayment (in Germany) where the foreign company repaying its equity makes an application (in favor of its shareholder) to the German Tax Authorities. The requirements however are strict and time barred 12 months after fiscal year-end in which the repayment took place.
Administrative rules for international and transfer pricing audits tighten significantly
Also adopted on Dec. 16, 2022, was a law aiming at modernizing the administration of taxes, especially the acceleration of tax audits. Being applicable for the most part only for tax periods starting in 2025 onwards, several important law changes are nonetheless significant enough to be mentioned:
- The transfer pricing documentation must be provided 30 days after a tax audit has been announced (before it was 60 days after request).
- Outside of tax audits, the transfer pricing documentation must be provided within 30 days after being requested by the tax authorities (e.g., in case of an APA).
- A so-called “qualified cooperation audit request” with a deadline of one month will be implemented.
- Sanctions for non-compliance and insufficient cooperation will be extended and increased.
In October of 2021, the European Union placed Hong Kong in Annex II (commonly known as “the watchlist”) of the list of non-cooperative jurisdictions for tax purposes. The EU’s main concern was the possible double non-taxation arising from the tax exemption for offshore passive income in the absence of any requirement for recipient companies to have a substantial economic presence in Hong Kong.
To address the issue, the Hong Kong Special Administrative Region Government proposed a refinement of its foreign source income exemption regime for passive income which will be effective for companies beginning Jan. 1, 2023. Four types of foreign-sourced passive income (i.e., interest, dividends, disposal gains in relation to shares or equity interests and intellectual property income) received in Hong Kong by multinational enterprises will be deemed as Hong Kong sourced and chargeable to Hong Kong profits tax unless the recipient entity can meet the exception requirements (e.g., economic substance requirement for non-IP income, nexus requirement for IP income).
Before she resigned as UK prime minister on Oct. 20, 2022, Liz Truss had already abandoned the proposal, announced by former chancellor of the exchequer, Kwasi Kwarteng, in his Sep. 23, 2022 ‘Growth Plan’, to reverse the increase in the main rate of UK corporation tax to 25% beginning on April 1, 2023. This increase has been written into UK law since 2021 and its proposed reversal was never formally adopted into legislation. Accordingly, the 25% rate should generally be used for the purposes of accounting for UK income taxes in respect of profits arising after April 1, 2023 and deferred tax assets and liabilities expected to reverse after that date.
The new chancellor, Jeremy Hunt, announced further changes to the taxation of UK companies in his Autumn Statement on Nov. 17, 2022. These notably included changes to the rates of research and development (R&D) tax relief for large companies (the taxable expenditure credit is to increase from 13% to 20%) and small and medium-sized companies (the enhanced deduction is to reduce from 130% to 86%, and the payable credit on losses arising from such enhanced expenditure is to reduce from 14.5% to 10%) from April 1, 2023. Previously announced measures in relation to the R&D tax reliefs, including changes to allow data and cloud computing costs to qualify for relief and to limit the relief available in respect of R&D undertaken by overseas workers, will go ahead for accounting periods beginning on or after that date.
The chancellor also reconfirmed the government’s intention to implement the OECD’s global minimum tax rules (known as ‘pillar two’) for accounting periods beginning on or after Dec. 31, 2023. As part of this, the UK will implement a qualifying domestic minimum tax (DMT) from that date, ensuring that groups with an effective tax rate on UK profits below the prescribed minimum of 15% will pay top-up tax in the UK, rather than overseas. In this regard, reforms to certain creative sector tax reliefs (relevant to film, television, and video game production companies) will be reviewed to ensure that they are fully compatible with pillar two and the DMT.
A summary and analysis of the measures announced at the Autumn Statement is provided in the alert from RSM UK: Autumn Statement 2022 | Detailed analysis.