September 24, 2021
Accounting methods and other domestic provisions would be affected by tax provisions in House Ways & Means Committee reconciliation bill
Recently proposed tax law changes in the Build Back Better Act reconciliation bill, which were approved by the House Ways & Means Committee, would affect taxpayers' accounting methods and other domestic provisions (the HW&M Proposal). To supplement the HW&M Proposal, the House Ways and Means Committee also released a section-by-section summary, and the Joint Committee on Taxation released a description of the proposed changes (the JCT report).
In this Tax Alert, EY discusses the Committee's domestic business tax proposals and certain international proposals that impact methods of accounting. The international proposals (including those affecting foreign tax credits (FTC), global low-tax intangible income (GILTI), the base erosion and anti-abuse tax (BEAT) and limitations on interest expense under IRC Section 163(j)), are discussed in detail in a related International Tax Alert. A separate Private Client Services Alert also has been issued.
For a discussion of prior releases of tax proposals and draft legislative text (as part of the Build Back Better Plan), see prior EY Alerts on the Biden Administration's Green Book proposal and Senate Finance Committee Chair Ron Wyden's proposal.
Domestic tax provisions
Corporate tax rate
The HW&M Proposal would establish a three-step graduated rate structure for taxing corporate taxable income. Under the graduated rate structure, the top corporate tax rate would be 26.5% on taxable income of more than $5 million. The HW&M proposal would impose an additional 3% tax on a corporation's taxable income in excess of $10 million, with a maximum additional tax of $287,000.
The HW&M Proposal also would increase the 50% dividends-received deduction to 60% and the 65% dividends-received deduction to 72.5%.
The HW&M Proposal would be effective for tax years beginning after December 31, 2021.
IMPLICATIONS: Taxpayers should consider the timing of IRC Section 451 changes and be careful if they implement those changes before the higher corporate rates become effective. Changes implemented incorrectly, if corrected in later tax years, could be subject to higher tax rates and, in many cases, non-automatic method-change procedures.
There could be an opportunity for tax savings through accounting method changes that increase 2021 income and/or decrease 2021 expenses. For calendar-year taxpayers, this opportunity includes automatic method changes filed before October 15, 2021.
Accounting method changes may also be considered in managing the taxable income limitation on the IRC Section 250 deduction for (1) foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI), (2) the annual limitation on interest deductibility under IRC Section 163(j), or (3) the taxpayer's exposure to base-erosion and anti-abuse tax (BEAT) liability under IRC Section 59A. Alternatively, a similar result to the accounting method changes could potentially be achieved through capitalization elections under various provisions, such as IRC Sections 59(e) (capitalization of research and experimental (R&E) expenditures), 174 (capitalization of R&D costs), 263 (e.g., capitalization of repair expenditures), 263A (e.g., capitalization of inventory costs) and 266 (capitalization of certain taxes, interest and carrying charges). Additional planning opportunities relate to the advance payment methodology, delayed payments for payment liabilities under IRC Section 461(h) and delayed funding for pensions.
Proposed changes to limit IRC Section 163 interest deductibility
The HW&M Proposal would add new IRC Section 163(n), which would limit the interest deductibility of certain domestic corporations that are part of a multinational group that prepares consolidated financial statements, according to the domestic corporation's allocable share of the group's net interest expense. This new limitation would apply in conjunction with current IRC Section 163(j) so that interest deductions could not exceed whichever limitation is more restrictive. However, proposed IRC Section 163(o) would allow any disallowed interest expense under IRC Section 163(j) or proposed IRC Section 163(n) to be carried forward only up to five years, unlike current IRC Section 163(j), which allows for indefinite carryforward.
An earlier version of IRC Section 163(n) was proposed as part of legislative efforts that culminated in the Tax Cuts and Jobs Act ((Public Law 115-97) (TCJA). Consistent with that version, proposed IRC Section 163(n) would apply to any domestic corporation that is part of an "International Financial Reporting Group," and not only foreign-parented multinationals. This contrasts with a similar rule, which was proposed earlier this year in the Green Book, that only applied to foreign-parented multinationals. Thus, proposed IRC Section 163(n) would apply to a large base of taxpayers.
The HW&M Proposal would be effective for tax years beginning after December 31, 2021.
IMPLICATIONS: Given the potential substantial modifications in the proposed legislation, as well as complexities under current law specific to adjustments made to adjusted taxable income (ATI) for depreciation and amortization (that will no longer be added back to increase ATI in 2022 and future tax years), 2022 tax years may be subject to particular focus for affected taxpayers. Interest deduction limitations in the context of global tax structures also will need to be considered, as applicable.
Delay in requirement to amortize R&E expenditures
The HW&M Proposal would delay the effective date of the TCJA's modifications to IRC Section 174 for four tax years. The TCJA's primary modifications require capitalization and amortization of R&E expenditures; the amortization period would be five years for research and development (R&D) performed in the United States and 15 years for R&D performed abroad. In addition, the modifications would deem all software development costs as IRC Section 174 R&E expenses.
If delayed, the TCJA's changes to IRC Section 174 would apply to amounts paid or incurred in tax years beginning after December 31, 2025.
IMPLICATIONS: Delaying the effective date for requiring capitalization and amortization of R&E expenditures would benefit taxpayers that are still following the current rules under IRC Section 174. Similarly, the delay would benefit taxpayers that previously fell outside the scope of IRC Section 174, but are now subject to the modifications due to the inclusion of all software development costs as IRC Section 174 costs.
The ability to choose among multiple methods of accounting and elections for R&E expenditures and software development costs, if the HW&M Proposal were enacted, would significantly benefit taxpayers in terms of research expense and recovery planning. The delayed effective date for required capitalization and amortization also would allow the IRS time to address concerns raised by taxpayers regarding the TCJA's changes to IRC Section 174.
For tax years beginning before January 1, 2025, taxpayers may opt to capitalize or deduct under current rules, depending on their specific tax position. Capitalization for 2020 or 2021 may defer deductions to higher rate years and should be considered. Until the TCJA's changes to IRC Section 174 are mandatory, taxpayers may want to consider capitalizing and amortizing R&E expenditures under IRC Section 59(a) (for IRC Section 174 costs that are currently treated as expenses) or under IRC Section 174(b), to defer deductions to years with higher tax rates.
Temporary rule allowing certain S corporations to reorganize as partnerships without tax
The HW&M Proposal would temporarily allow an eligible S corporation to elect to reorganize as a partnership without the S corporation or its shareholders being subject to income tax. The qualified liquidation of an eligible S corporation would be treated as a complete liquidation under IRC Section 332(b), and the transferee domestic partnership would be treated as (i) if it were a corporation that is an 80% distributee under IRC Section 337(c)), and (ii) the eligible S corporation's successor corporation for purposes of IRC Section 1362(g).
The HW&M Proposal would define "qualified liquidation" as one or more transactions that occur within a two-year period beginning on December 31, 2021, and constitute the eligible S corporation's complete liquidation. A qualified liquidation would also include the transfer of substantially all of the S corporation's assets and liabilities to a domestic partnership.
Once the reorganization is completed, the HW&M Proposal would allow the former S corporation to make non-pro-rata allocations of income, gain, loss, deduction and credits to the partners.
The HW&M Proposal would be effective for transactions occurring on or after December 31, 2021, and before January 1, 2024.
Worthless partnership interests and securities
The HW&M Proposal would add new IRC Section 165(m), providing that if any interest in a partnership becomes worthless, the loss would be treated as arising from the sale or exchange of a partnership interest under IRC Section 741. Additionally, it would extend the IRC Section 165(g) rules applicable to worthless securities to securities issued by partnerships.
The HW&M Proposal would accelerate the timing of a loss from a worthless security and would treat the loss as arising from the sale or exchange of a security at the time of the identifiable event establishing worthlessness. Taxpayers could defer losses from a complete liquidation to which IRC Section 331 applies when the two corporations were members of the same controlled group. The HW&M Proposal would not allow the distributee corporation to recognize any loss on the stock or securities received in the liquidation until it disposed of substantially all of the stock or securities it received in the liquidation to an unrelated party.
The HW&M Proposal would apply to tax years beginning after December 31, 2021. For liquidations, the HW&M Proposal would apply to liquidations on or after the date of enactment.
Limitation on deduction of qualified business income
The qualified business income (QBI) deduction under IRC Section 199A allows a taxpayer to deduct up to 20% of QBI. Amending IRC Section 199A, the HW&M Proposal would limit the maximum allowable deduction to $500k for a joint return, $400k for an individual return, $250k for a married individual filing separately, and $10k for a trust or estate. These limits would apply for tax years beginning after December 31, 2021. IRC Section 199A currently applies for tax years beginning on or before December 31, 2025.
IMPLICATIONS: In lowering the corporate rate to 21% in the TCJA, a widening gap emerged between corporate and partnership tax rates. To try to close that gap, IRC Section 199A was introduced, providing a 20% deduction for certain income from sole proprietorships and pass-through entities. For individuals owning qualifying businesses, the proposed limitation of this preference could substantially raise their amount of taxable income. Based on estimates by the Joint Committee on Taxation, the proposed limitation would raise revenue of approximately $78M before IRC Section 199A sunsets.
Limitations on excess business losses of noncorporate taxpayers
Amending IRC Section 461(l), the HW&M proposal would permanently disallow noncorporate taxpayers from claiming excess business losses (i.e., net business deductions exceeding business income). However, disallowed losses could be carried forward to the next tax year. These changes would apply for tax years beginning after December 31, 2020.
Treatment of certain qualified sound recording productions
The HW&M Proposal would expand IRC Section 181's special expensing rules for qualified film, television and live theatrical productions to include qualified sound recording production costs of up to $150,000 per tax year. It would define a qualified sound recording production "as a sound recording (as defined in section 101 of title 17 of the US Code) produced and recorded in the United States."
In addition, the HW&M Proposal would broaden the definition of qualified property eligible for bonus depreciation to include qualified sound recording productions. Under the proposal, the production costs that exceeded $150,000 would qualify for bonus depreciation once the production was placed in service. The HW&M Proposal would consider a qualified sound recording production as placed in service when it is first released or broadcasted.
The HW&M Proposal would apply to productions beginning in tax years ending after the date of enactment. Note that IRC Section 181 expires on December 31, 2025.
IMPLICATIONS: A similar earlier bill had been introduced in March of this year, Help Independent Tracks Succeed Act or HITs Act. It appears that the intent of the HW&M proposal is to help independent musicians and producers by providing benefits currently available for film and television production.
The potential expansion of bonus depreciation to include qualified sound recordings appears to be a logical extension of the bonus depreciation rules as modified under the TCJA. With this said, interest will continue to exist for both taxpayers and practitioners specifically around whether 100% bonus depreciation will get extended in continued talks or whether it will begin to sunset 20% per year beginning in 2023 and continuing through 2026 generally.
International tax provisions
Highlights of notable tax changes that may affect accounting method planning considerations (including for inventories), include, but are not limited to, the following items.
Controlled foreign corporation (CFC) tax years
The HW&M Proposal would repeal the one-month deferral election for CFC tax years beginning after November 30, 2021. Thus, a CFC using a one-month deferral year would be required to change to its majority US shareholder year. A transition rule would provide that a taxpayer's first tax year beginning after November 30, 2021, would end at the same time as the first "required" year ending after that date. Therefore, CFCs with a tax year ending November 30, 2021, under a one-month deferral election would automatically have a short tax year ending December 31, 2021.
IMPLICATIONS: Changes to conform to proper accounting methods could potentially be subject to lower tax rates (e.g., reflecting GILTI modifications) if the adjustments are increases to income for short CFC years ending before the effective date of the proposed legislation. Whether the IRS would make modifications to present method change eligibility rules is uncertain, both in the CFC context and more broadly.
CFCs using a one-month deferral would have an additional tax year before the increased rates took effect to take advantage of method change opportunities, including an additional 481 year at the lower rate for changes made in 2020 or 2021.
Inclusion of GILTI and subpart F income
The HW&M Proposal would apply GILTI on a country-by-country basis to require a US shareholder to include in gross income under IRC Section 951A separate per-country GILTI amounts based on the tested income, tested loss, qualified business asset investment (QBAI) and interest expense allocable to gross tested income of "CFC taxable units" that are residents of the same country. Applying GILTI on a per-country basis conforms with the changes the HW&M Proposal would make to apply the FTC limitation on a per-country basis.
Also, the HW&M Proposal would retain the current offset of 10% of QBAI against deduction-eligible income (DEI), whereas for purposes of computing GILTI, net tested income would be reduced by only 5% of a CFC's QBAI. These changes, along with a host of other significant modifications to the GILTI regime contained in the HW&M Proposal, may represent a gradual erosion of the complementary relationship between FDII and GILTI, which was described as a key objective of the IRC Section 250 deduction when enacted as part of the TCJA.
IRC Section 250 and FDII and GILTI
The HW&M Proposal would retain, but modify, the deduction for FDII and largely retain the existing framework of IRC Section 250, with several noteworthy modifications. This contrasts with President Biden's Green Book, which would repeal FDII in its entirety, and the Senate Finance Committee Chair's more recent proposal, which would collapse the IRC Section 250 deduction into a single rate for both FDII and GILTI and replace, or eliminate, some components of the current FDII formula.
The HW&M Proposal would reduce the percentages a domestic corporation uses to compute its IRC Section 250 deduction in a tax year, which would yield a lower deduction for taxpayers. Also, a corporation would determine its DEI — a key driver of the FDII component of the deduction — by excluding certain additional categories of gross income from DEI. Lastly, the HW&M Proposal would repeal the taxable income limitation under IRC Section 250(a)(2) and allow the IRC Section 250 deduction to be taken into account in computing a corporation's net operating loss (NOL), as well as the rate at which NOLs are utilized in carryover years.
IMPLICATIONS: The proposals to repeal the IRC Section 250(a)(2) taxable income limitation would likely be welcome changes for taxpayers. Together, they would preserve a taxpayer's full IRC Section 250 deduction, whether in the form of a current-year deduction or an NOL carryover, or both, by enabling the IRC Section 250 deduction to generate and/or increase a taxpayer's NOL.
The HW&M Proposal would significantly modify IRC Section 59A. Of significance for US multinational groups is a provision that would except an amount from treatment as a "base erosion payment" if US income tax were imposed on the amount. The HW&M Proposal would also make certain modifications to BEAT to incorporate the concepts of the Stop Harmful Inversions and Ending Low-Tax Developments (SHIELD) proposal put forth by the Biden Administration.
More generally, the HW&M Proposal would retain the general framework of IRC Section 59A, including certain key exceptions, e.g. the exception to the services cost method. The gross receipts threshold that applies to determine whether a taxpayer is subject to BEAT would also be retained, though the base erosion percentage threshold would be eliminated prospectively for any tax year beginning after December 31, 2023. The HW&M Proposal would also modify the treatment of cost of goods sold (COGS) and would treat certain payments to foreign related parties for which an amount must be capitalized under IRC Section 263A as base erosion payments.
The HW&M Proposal would add two new exceptions to the definition of a base erosion payment. First, proposed IRC Section 59A(i) would not treat an amount as a base erosion payment if US federal income tax were imposed with respect to that amount, determined under rules similar to the rules of IRC Section 163(j)(5) (as in effect before the TCJA's enactment date). According to the JCT Report, "payments that are subject to US income tax by either the payor or the payee are outside the scope of base erosion payments, without regard to whether the income related to such payments was eligible for a reduced rate of tax. Thus, outbound payments to a related party that are included in the computation of GILTI … , subject to withholding tax or taxable as effectively connected income to the recipient are not base erosion payments. Whether a payment is subject to Federal income tax is determined using principles similar [to] those in former [IRC Section] 163(j)(5)."
Second, proposed IRC Section 59A(i) would exclude from treatment as a base erosion payment any amount that the taxpayer established was subject to an effective rate of foreign income tax that is not less than the BEAT rate (i.e., currently 10%, 12.5% for tax years beginning after December 31, 2023, and 15% for tax years thereafter) for the tax year in which the amount is paid or accrued. This exception appears to incorporate elements of SHIELD. According to the JCT Report, the effective tax rate is computed in the same manner as under the provisions of IRC Section 904, and may be established on the basis of applicable financial statements (as defined in IRC Section 451(b)(3)), except as otherwise provided in regulations.
Limitation of the base erosion percentage test
Under current law, BEAT applies if certain thresholds are met, including a base erosion percentage test of 3% or more (2% or more for a taxpayer that is a member of an affiliated group with a domestic bank or registered securities dealer). The HW&M Proposal would eliminate the base erosion percentage test for tax years beginning after December 31, 2023. Thus, BEAT could apply for any tax year beginning on or after January 1, 2024, if the taxpayer satisfies the gross receipts test (i.e., has average annual gross receipts of at least $500 million for the prior three years).
Increased BEAT rates
Under current law, the ordinary BEAT rate is 10%, with a scheduled increase from 10% to 12.5% for tax years beginning after December 31, 2025. The HW&M Proposal would expedite this increase in the BEAT rate from 10% to 12.5% for tax years beginning after December 31, 2023, and before January 1, 2026, and then further increase the BEAT rate from 12.5% to 15% for tax years beginning after December 31, 2025.
The HW&M Proposal would also expand the scope of taxpayers subject to the higher BEAT rate that currently applies only to banks and registered securities dealers. Specifically, current law increases the BEAT rate by one percentage point for applicable taxpayers that are banks (as defined in IRC Section 581) or registered securities dealers. The HW&M Proposal would instead define "bank" by reference to IRC Section 585(a)(2), which includes not only banks as defined in IRC Section 581 but also corporations that would be a bank (under IRC Section 581) if they were domestic, rather than foreign, corporations. This change means that foreign banks with a US branch presence would now be subject to higher BEAT rates and a lower base erosion percentage threshold in the same manner as US banks, even if the branch operates on a stand-alone basis in the US (i.e., not in an affiliated group with a broker dealer or IRC Section 581 bank). The HW&M Proposal would also expand the application of higher BEAT rates and a lower base erosion percentage threshold to members of an affiliated group (as defined in IRC Section 1504(a)(1), determined without regard to IRC Section 1504(b)(3)), which includes the US branch of a foreign bank as defined under IRC Section 585(a)(2).
Calculation of BEAT liability
Under current law, an applicable taxpayer's "base erosion minimum tax amount" (BEMTA) equals the excess, if any, of the BEAT rate (e.g., 10%) multiplied by the taxpayer's "modified taxable income" (MTI) over the taxpayer's regular tax liability as reduced (but not below zero) by all income tax credits except for the research credit and a certain portion of other IRC Section 38 credits. The HW&M Proposal would modify the BEMTA definition such that an applicable taxpayer's regular tax liability would not be reduced by any credits (including foreign tax credits), potentially resulting in a larger offset against the BEAT rate as applied to modified taxable income.
The HW&M Proposal would also amend the definition of "net income tax" under IRC Section 38(c)(1) by including a reference to the tax imposed by IRC Section 59A. This change would mean that an applicable taxpayer's BEAT liability would be taken into account for purposes of the limitation on general business credits allowed under IRC Section 38(a). According to the JCT report, it is intended that taxpayers may apply general business credits under IRC Section 38 to offset the BEAT liability, though additional modifications may be necessary to achieve that result.
Adjustments to MTI
The HW&M Proposal would also modify the amount of the NOL deduction taken into account for purposes of computing MTI. Under current law, the NOL deduction for purposes of computing MTI is determined without regard to the base erosion percentage of any NOL. The base erosion percentage for any tax year is generally the aggregate amount of base erosion tax benefits for the year (the numerator) divided by the aggregate deductions for the year (including base erosion tax benefits) but excluding deductions allowed under IRC Sections 172, 245A or 250, and certain other deductions that are not base eroding payments.
Under the HW&M Proposal, the NOL deduction for purposes of computing MTI would be determined without regard to any deduction that is a base erosion tax benefit. Moreover, the HW&M Proposal would modify IRC Section 172, with respect to the MTI adjustment, to provide that the 80% limitation on an NOL deduction applies with respect to MTI (rather than taxable income). Thus, for purposes of calculating MTI, the general cap on the NOL deduction for any tax year would be 80% of MTI (rather than 80% of taxable income). Corresponding modifications would be provided for measuring the remaining amount of the NOL deduction available in subsequent carryforward years.
The HW&M Proposal would also modify the MTI according to other adjustments, similar to the rules applicable to IRC Section 59. Specifically, new IRC Section 59A(c)(1)(D) would provide that rules similar to the rules of IRC Section 59(g) (Tax Benefit Rule) and IRC Section 59(h) (Coordination with Certain Limitations) would apply for purposes of determining the MTI of an applicable taxpayer.
The HW&M proposal would introduce significant changes to MTI in IRC Section 59A(c). Notably, the HW&M proposal would add a new IRC Section 59A(d)(5), which would treat certain payments for inventory as base erosion payments and, therefore, exclude them from the calculation of COGS for purposes of determining MTI.
Subject to the exceptions discussed later for amounts that are subject to a US income tax or a sufficient effective rate of foreign income tax, the expanded definition of base erosion payment would include certain indirect costs that are paid or accrued by the taxpayer to a foreign related party and must be capitalized to inventory under IRC Section 263A (e.g., royalty costs incurred to secure the use of certain intellectual property/rights). The expanded definition would also include the portion of the invoice price of inventory purchased from a foreign related party that exceeds the sum of (i) the direct costs of such property (but see the later discussion of the look-through rule for tiered transactions) plus (ii) indirect costs that would be capitalizable under IRC Section 263A that are paid or accrued by the foreign person to a US person or a person that is not a related party of the taxpayer or amounts otherwise subject to tax
In a tiered transaction, direct costs paid or incurred by one foreign related party to another foreign related party are not subject to BEAT, but only to the extent they are ultimately attributable to amounts paid or accrued (directly or indirectly) to a US person or a person that is not a related party.
Instead of "looking through" to the foreign related party's actual indirect costs to determine the amount described in (ii) above, taxpayers could use a safe harbor, which would treat 20% of the amount paid or incurred by the taxpayer to the related party to purchase the inventory as indirect costs excludible from the definition of base erosion payments.
IMPLICATIONS: While the overall inventory related modifications to the definition of a base erosion payment are generally not taxpayer favorable, it is important to note that many of these payments could still be excluded from the definition of a base erosion payment if either the exception for payments subject to sufficient foreign tax applied, or the exception for payments subject to US tax applied. If neither of the exceptions apply, this proposal could have a significant unfavorable impact on a taxpayer's BEAT liability with respect to costs capitalized to inventory and recovered as COGS.
Under the current BEAT rules, costs that are capitalized to inventory are not base erosion payments because the amounts are recovered as a reduction to gross receipts (i.e., COGS) and are not deductions. The HW&M proposal would treat indirect costs that were incurred by the US taxpayer, capitalizable to inventory under IRC Section 263A and paid to a foreign related party as base erosion payments unless the previously noted exceptions apply. Further, under the current BEAT rules, the entire invoice price of inventory purchased by a US taxpayer from a foreign related party is capitalized to inventory and, as such, is not a base erosion payment. The HW&M proposal would modify that treatment and require US taxpayers to analyze the invoice price to determine the portion of the purchase price that relates to direct and indirect costs incurred by the foreign related party. It would also require US taxpayers to determine which portion of those costs (1) were paid or accrued by the foreign related party(ies) to a US person, (2) were paid or accrued by the foreign related party(ies) to a person unrelated to the US person, or (3) are otherwise subject to US income tax.
A detailed Tax Alert is forthcoming with additional inventory implications and examples.