March 31, 2020
CARES Act adopts technical amendments for qualified improvement property and provides broad relief for many taxpayers, including provisions related to IRC Section 163(j), NOL deductions and AMT acceleration
Enacted in response to the COVID-19 pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act provides roughly $2 trillion in economic relief to eligible businesses and individuals impacted by the novel coronavirus outbreak. The CARES Act is significant legislation that will affect nearly every corner of the economy.
This Tax Alert discusses key federal tax provisions (including potential accounting methods implications and planning opportunities) of the CARES Act for corporate and certain other affected taxpayers. These provisions will impact companies seeking sources of liquidity through net operating loss (NOL) carryback claims and income tax refunds, as well as other similarly situated taxpayers. This Tax Alert also provides insights for those seeking to understand how the CARES Act will affect federal tax-planning related to mergers and acquisitions and associated accounting method implications that may arise from an increased prevalence of restructuring in the current economic environment. For further detail regarding the various provisions of the CARES Act, see other Tax Alerts, including Tax Alert 2020-0708 and Tax Alert 2020-9011.
The CARES Act made key technical amendments for qualified improvement property (QIP) and modified the limitation on business interest under IRC Section 163(j). Affected taxpayers will need to carefully consider the interaction of various amended Code provisions and may need to engage in financial modelling to determine the best use of available deductions as well as, when applicable, various tax attributes such as NOLs during the limited periods in which these taxpayer-favorable changes are in place. In addition, taxpayers should evaluate restructuring opportunities that may permit them greater utilization of certain tax attributes. These restructuring opportunities may present an opportunity for taxpayers to thoroughly analyze their transaction costs. Additionally, consideration should be given to accounting method change or adoption considerations associated with restructuring, including the potential relevance of IRC Section 381 and the underlying regulations.
In summary, this Tax Alert will discuss in more detail bonus depreciation for QIP and will provide an overview of the following other taxpayer-favorable federal tax amendments made by the CARES Act:
Qualified improvement property
As background, when the Tax Cuts and Jobs Act (TCJA) eliminated the separate definitions of qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property and provided for a single definition for QIP under IRC Section 168(e)(6), we understand that Congress intended to provide a 15-year recovery period for QIP placed in service after December 31, 2017. Due to an apparent oversight, however, IRC Section 168(e)(3)(E), the provision generally describing the property to which a 15-year recovery period applies, was not amended to include QIP. As a result, QIP acquired after September 27, 2017, and placed in service after December 31, 2017 had to be recovered over 39 years and, accordingly, was not eligible for bonus depreciation. (However, QIP acquired after September 27, 2017, and placed in service on or before December 31, 2017, was eligible for bonus depreciation and, therefore, was not at issue in the CARES Act changes described herein.)
The TCJA also extended the bonus depreciation deduction through 2026. The TCJA allows taxpayers to claim 100% bonus depreciation for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023, phasing down bonus depreciation to 80% for qualified property placed in service before January 1, 2024; 60% for qualified property placed in service before January 1, 2025; 40% for qualified property placed in service before January 1, 2026; and 20% for qualified property placed in service before January 1, 2027. The TCJA specifies that qualified property includes tangible property with a recovery period of 20 years or less under MACRS, provided the remaining requirements of IRC Section 168(k)(2) are met. The TCJA, however, removed the specific reference to QIP as being qualified property and, as a result, QIP was not eligible for bonus depreciation.
The CARES Act amends IRC Section 168(e)(3)(E) to retroactively include the QIP inadvertently classified as 39-year property under the TCJA as property to which a 15-year recovery period applies and for which bonus depreciation may be claimed. Under the TCJA, taxpayers may claim 100% bonus depreciation for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. Because of the new technical amendments, taxpayers that make or have made improvements to their facilities may now take appropriate steps to claim the missed 2018 100% bonus depreciation.
As described in the summary later and pending additional anticipated Treasury Department guidance that potentially may provide more flexibility or change other analytical considerations, to claim bonus depreciation for QIP, a taxpayer may choose to amend prior-year tax returns before filing 2019tax returns. Alternatively, a taxpayer may decide to file Form 3115, Application for Change in Accounting Method, under Section 6.01 of automatic Revenue Procedure 2019-43, to claim missed bonus depreciation, assuming all scope requirements of the existing procedure are met.
Options for properly depreciating QIP over 15 years
For taxpayers that have not yet filed a 2019 return. To correct the depreciation for QIP placed in service in 2018, a taxpayer generally can either amend the 2018 federal income tax return or file an automatic accounting method change for the 2019 tax year or a later tax year under current procedural guidance (i.e., Section 6.01(1)(a) and (b) of Revenue Procedure 2019-43). Section 6.01(1)(b) waives the application of the "two-year rule" for impermissible to permissible changes so taxpayers can depreciate property wrongly in one year and file a change in the following year.
For taxpayers preparing to file a 2019 return. Treatment of QIP placed in service in 2019 will not directly impact depreciation issues for QIP placed in service in 2018. If the 2019 federal income tax return is filed in a manner that ignores the CARES Act QIP "fix" for QIP placed in service in 2018 (i.e., depreciation continues straight line over 39 years), however, then an accounting method will be established and the improper treatment can generally only be corrected through a method change (absent more generous procedural guidance that may be issued by the Treasury Department). If the 2019 return is filed in a manner that takes the correct depreciation for QIP placed in service in 2018 (i.e., 2019 federal income return reflects $0 depreciation for QIP placed in service in 2018), the taxpayer may still be able to amend the 2018 tax return to take the missed bonus depreciation in 2018 (assuming the tax year is still open from a statute of limitations standpoint). This would generally preclude a method change in a future tax year.
For taxpayers that have already filed a 2019 federal income tax return using the "old", prior QIP method. If the 2019 tax return was filed in a manner that ignores the QIP fix for QIP placed in service in 2018 (i.e., depreciation continues straight-line over 39 years), then an accounting method will be established and the improper treatment can generally only be corrected through a method change (absent more generous procedural guidance issued by the Treasury Department).
Determining the best year to take the additional QIP deductions (e.g., 2018, 2019, 2020) depends on many factors, including actual and/or projected taxable income, any desire to apply carryback provisions, the need for cash (i.e., consider 4/15 prompt refund filing deadline in appropriate cases), other cash tax planning, interaction with NOL rules, IRC Section 163(j) provisions, various international tax provisions (e.g., BEAT, GILTI, IRC Section 965, and FDII), and other provisions applicable to a taxpayer. As indicated in the implications, modeling of this and other CARES Act changes will be critical.
Business interest deductions
The CARES Act modifies IRC Section 163(j), a Code provision that affects many types of businesses and which was substantially modified by the TCJA in 2017.
IRC Section 163(j) limits the amount of business interest expense that may be deducted in a tax year to an amount that cannot exceed the sum of (1) the taxpayer's business interest income for the year; (2) 30% of the taxpayer's adjusted taxable income (ATI) for the year; and (3) the taxpayer's floor plan financing interest expense for the year. For the years in question, ATI may be roughly analogized to the financial concept of earnings before interest, taxes, depreciation and amortization (e.g., EBITDA).
The CARES Act changes the ATI limitation, increasing it from 30% to 50%, but only for tax years that begin in 2019 or 2020. A contemplated election would permit a taxpayer to opt out of the 50% limitation. Moreover, another special election permits a taxpayer to use its 2019 ATI in lieu of 2020 ATI, with a pro-ration mechanism for short tax years.
For example, corporate taxpayers that otherwise would have been disallowed business interest expense (the amount in excess of 30% of ATI, up to 50%) may be able to deduct more business interest expense in 2019 and 2020. Also, given a possible economic downturn in 2020, many taxpayers will have greater ATI in 2019 than 2020; in such case, the election mechanism (to use 2019 ATI in lieu of 2020 ATI) generally provides the ability to deduct more interest expense in 2020 than otherwise would be permitted. Of course, the additional interest expense that may be deducted may give rise to, or increase, an NOL, which, as previously discussed, may now be carried back to offset the taxable income of five prior tax years.
NOLs and NOL carrybacks for corporate taxpayers
Under the CARES Act, NOLs arising in tax years beginning after December 31, 2017, and before January 1, 2021 (e.g., NOLs incurred in 2018, 2019, or 2020 by a calendar-year taxpayer) may be carried back to each of the five tax years preceding the tax year of such loss. Since the enactment of the TCJA, NOLs generally could not be carried back but could be carried forward indefinitely. Further, the TCJA limited NOL absorption to 80% of taxable income. The CARES Act temporarily removes the 80% limitation, reinstating it for tax years beginning after 2020. Special carryback rules are provided for taxpayers, such as real estate investment trusts (REITs) and life insurance companies.
As a result of changes under the CARES Act, corporate taxpayers with eligible NOLs may now be able to claim a refund for tax returns from prior tax years. The CARES Act did not modify IRC Section 172(b)(3), so, when advantageous, a taxpayer can still waive the carryback and elect to carry NOLs forward to subsequent tax years. Further, in eligible tax years, corporate taxpayers may use NOLs to fully offset taxable income, rather than the 80% limitation.
Many taxpayers — particularly multinational corporate groups that own controlled foreign corporations (CFCs) — will need to carefully consider the interaction of an NOL carryback with other Code provisions. For example, a taxpayer that elects to apply an NOL carryback to a tax year in which the IRC Section 965 transition tax was imposed will generally be precluded from taking its IRC Section 965 inclusion when determining the amount of taxable income that may be offset by NOL carrybacks. The CARES Act does not, however, generally prohibit taxpayers from using an NOL from a tax year with a lower corporate tax rate (e.g., 2020) to offset taxable income that was subject to a higher corporate tax rate in an earlier tax year (e.g., 2017).
Moreover, before claiming an NOL carryback for a prior tax year, corporate taxpayers should also consider how other tax attributes (e.g., foreign tax credits) that were absorbed in a prior year may now be displaced as a result of the carryback. Other considerations include the impact on the taxpayer's AMT liability, if any, in the carryback year.
Consolidated return groups will need to consider the computation and availability of consolidated NOLs, the allocation of that NOL to a departing consolidated return member and the group's utilization of a member's separate return loss year NOL. Taxpayers that were party to an M&A transaction may also need to consider contractual limitations affecting their ability to carry back, or carry over, an NOL.
Acceleration of minimum tax credit for corporate taxpayers
The TCJA repealed the corporate AMT, allowing corporate taxpayers to fully offset regular tax liability with minimum tax credits. Any remaining minimum tax credit amount became refundable incrementally from 2018 through 2021. The CARES Act accelerates the refund schedule, permitting corporate taxpayers to claim the refund in full in either 2018 or 2019. Taxpayers wishing to accelerate an AMT credit refund for 2018 may use a quick refund procedure (e.g., Form 1139) to claim these credits.
We understand that the Treasury Department intends to prioritize the issuance of guidance related to this provision (e.g., procedural guidance regarding how to implement the new QIP eligibility provisions, as well as guidance addressing the ability of taxpayers to formally elect out of bonus depreciation, if desired, in light of this recent statutory change). As previously stated, taxpayers assessing these provisions may need to undertake a careful assessment of factors including, but not limited to, the interaction of new rules related to NOLs and IRC Section 163(j), as well as any applicable international tax considerations consistent with the discussion that follows. The summary framework for QIP bonus depreciation is based on general rules and we are aware that the Treasury Department is working on procedural guidance. As noted, Treasury could allow for greater flexibility than the current rules provide or make other changes not reflected in the prior summary.
Other accounting method and additional implications
More broadly, the ability to use optimal accounting methods in the current economic climate cannot be overemphasized in terms of potential immediate impact on cash flow. Taxpayers seeking to enhance cash flow in the short term should consider the availability of automatic accounting method changes for 2019 tax years, such as those related to wholly and partially worthless bad debts, depreciation, prepaid expenses and the recurring item exception, and the uniform capitalization rules. Taxpayers should also be aware of the effects of elections under IRC Sections 280C and 59(e) on 2019 R&D credits and expenses, and model how making those elections may affect tax liability for federal and state purposes.
As previously noted, restructurings present the opportunity to properly account for transaction costs under Treas. Reg. Section 1.263(a)-5, which governs amounts paid or incurred to facilitate an acquisition of a trade or business, or a change in capital structure of a business entity, as well as certain other transactions.
Two additional points should be emphasized relative to the significant near-term impact on tax planning, reflecting the somewhat conflicting goals of caution and speed. First, while this legislation is clearly designed to be taxpayer-favorable and is likely to improve the near-term cash flow of many corporate taxpayers, the decision to pursue a refund through an NOL carryback should be carefully considered for all of its knock-on effects, such as the effect on AMT liability in a carryback year (particularly where some or all of an associated AMT credit may have been recovered in subsequent years). Similarly, multinational groups with CFCs should be particularly mindful in considering the panoply of other Code provisions — many of which were enacted with the TCJA — that interact with an NOL deduction and could be affected by wholesale carryback decisions. Taxpayer profiles vary — for some, the modelling exercise and corresponding refund decision will be relatively straightforward, but there are many corporate taxpayers who will benefit from more thorough, nuanced, quantitative decision making.
A competing consideration to emphasize is the relatively limited window within which to act. The most significant IRC changes previously discussed are not permanent; e.g., the relaxed rules on NOL carrybacks and the elimination of the 80% taxable limitation for NOL absorption apply for only three tax years, two of which have already passed (for calendar-year taxpayers). Meanwhile certain elective mechanisms must be exercised within a relatively short window (e.g., within 120 days of the CARE Act's March 27, 2020 enactment date).
Most corporate taxpayers will find the modest IRC changes made by the CARES Act to be quite helpful. The Code's complexity, however, requires most corporate taxpayers to consider the overall impact on their tax profile carefully before taking advantage of the CARE Act's changes.