April 1, 2022
President's FY2023 budget includes proposals affecting accounting methods and calculation of taxable income
The President's FY2023 budget includes proposals that would affect how certain income and deductions are calculated for federal income tax purposes, such as the new undertaxed profits rule and tax incentives for locating jobs in the United States. For a discussion of international tax budget proposals, please see Tax Alert 2022-0514., Subject to exceptions, the proposals are generally effective in tax years beginning after December 31, 2022.
The following proposals would have federal income tax implications:
Corporate income tax rate increase: The proposal would increase the corporate income tax rate from 21% to 28%, effective for tax years beginning after December 31, 2022.
Undertaxed profits rule: The proposal would replace the Base Erosion Anti-Abuse Tax (BEAT) with an undertaxed profits rule (UTPR) that is consistent with the UTPR in the OECD's Pillar Two Model Rules. The UTPR would apply to foreign-parented multinationals operating in low-tax jurisdictions and financial reporting groups that have global annual revenue of $850m or more in at least two of the prior four years. The proposal would be effective for tax years beginning after December 31, 2023. Because it maintains the BBBA proposals, the Budget does not propose to repeal the deduction for foreign-derived intangible income (FDII). This contrasts with President Biden's FY2022 Budget, released in May 2021, proposing to repeal FDII in its entirety.
Tax incentives for locating jobs in the United States: The proposal would create a new general business credit equal to 10% of the eligible expenses paid or incurred when onshoring a trade or business to the United States. "Onshoring" means reducing or eliminating a trade or business or line of business currently conducted outside the United States and starting up, expanding, or moving the trade or business within the United States, to the extent US jobs increase. The proposal would be effective for expenses paid or incurred (depending on whether taxpayer is subject to the cash or accrual method) after the date of enactment.
Minimum income tax on wealthiest taxpayers: The proposal would impose a minimum 20% tax on the total income (generally including unrealized capital gains) of individual taxpayers whose wealth (defined as assets minus liabilities) exceeds $100m. The proposal would be effective for tax years beginning after December 31, 2022.
Repeal deferral of gain from like-kind exchanges: The proposal would allow the deferral of gain, up to an aggregate amount of $500,000, for each taxpayer ($1m for married individuals filing a joint return) each year for like-kind exchanges of real property. Taxpayers would recognize gains from like-kind exchanges exceeding $500,000 during a tax year (or $1m for married individuals filing a joint return) in the year they transfer the real property subject to the exchange. The proposal would be effective for exchanges completed in tax years beginning after December 31, 2022.
Recapture of gain on IRC Section 1250 property: The proposal would treat any gain on IRC Section 1250 property held for more than one year as ordinary income to the extent of the cumulative depreciation deductions taken after the proposal goes into effect. Depreciation deductions taken before the effective date would continue to be subject to the current rules and only be recaptured as ordinary income to the extent depreciation exceeds the cumulative allowances determined under the straight-line method. The proposal would be effective for depreciation deductions taken on IRS Section 1250 property in tax years beginning after December 31, 2022, and sales, exchanges, involuntary conversions, or other dispositions of IRC Section 1250 property completed in tax years beginning after December 31, 2022.
Foreign exchange gain or loss rules for individuals: The proposal would allow individuals living and working abroad to compute qualified compensation received in foreign currency and other items of income or expense by using an average exchange rate for the year to simplify and reduce present computational burdens. The personal exemption amount for foreign currency gain would increase from $200 to $500 and would be indexed for inflation. The proposal would be effective for tax years beginning after December 31, 2022.
Nonrecognition rules for securities loans of actively traded digital assets: The proposal would apply the securities loan nonrecognition rules under IRC 1058 to loans of "actively traded digital assets recorded on cryptographically secured distributed ledgers." These loans must have terms similar to the terms currently required for loans of securities. The proposal also would require the lender to consider the income that the lender would have made if it had continued to hold the asset, with appropriate basis adjustments when the loaned asset is returned. The proposal would be effective for tax years beginning after December 31, 2022.
Mark-to-market rules for actively traded digital assets: The proposal would allow dealers or traders of digital assets to use the mark-to-market method of accounting for actively traded digital assets and their derivatives or hedges. Treasury would be authorized to determine which digital assets were treated as actively traded by considering relevant facts and circumstances, such as (1) whether they are regularly bought and sold for a fiat currency, (2) their trading volume on exchanges that have reliable valuations, and (3) reliable price quotations. The proposal would be effective for tax years beginning after December 31, 2022.
Fixed indemnity health policies: The proposal would clarify that only payments for a specific medical expense would fall under the exclusion from gross income for payments received through an employer-provided accident or health plan. Fixed payments to an employee under a fixed indemnity arrangement, regardless of the actual cost of the medical expenses incurred, would be included in gross income and subject to FICA and FUTA taxes. Under the proposal, fixed indemnity arrangements would include certain critical disease or specified disease policies and arrangements under which fixed payments would be made for specific items and services according to detailed payment schedules. These payments would be subject to federal income, FICA and FUTA taxes. The proposal would allow individuals who purchase accident or health policies with after-tax dollars to exclude from gross income fixed payments made through those policies. The proposal would be effective for tax years beginning after December 31, 2022.
On-demand pay arrangements: The proposal would add a definition for on-demand pay arrangements to IRC Section 7701. An "on-demand pay arrangement" would be defined as an arrangement that allows employees to withdraw earnings before their scheduled pay dates. The proposal also would amend IRC Section 3401(b) to treat the payroll period for on-demand pay arrangements as a weekly payroll period, even if employees have access to their wages during the week. Additionally, the proposal would amend IRC Sections 3102, 3111, and 3301 to clarify that on-demand pay arrangements are not loans and IRC Section 6302 to establish special payroll deposit rules for these arrangements. The proposal would be effective for calendar years and quarters beginning after December 31, 2022.
In general. The Budget generally focuses on increasing both revenue and the progressivity of federal tax provisions, with particular focus on increasing rates for corporations and high net-worth individuals, as well as certain property transactions.
Corporate rate changes. Affected taxpayers should carefully evaluate their current accounting methods and elections, as well as contractual provisions, in light of the proposed corporate rate change. As part of this review, consideration should be given to accounting method changes and similar opportunities that may accelerate income recognition and/or deferral of deductions. Consideration also should be given to potential implications for global intangible low-taxed income, BEAT, FDII and other affected provisions.
Interestingly, the proposed increase in the corporate tax rate would be effective for tax years beginning after December 31, 2022; for tax years beginning before January 1, 2023, and ending after December 31, 2022, the corporate income tax rate would be prorated, i.e., equal to 21% plus 7% times the portion of the tax year that occurs in 2023. Thus, the effective date language appears to expressly incorporate the principles of IRC Section 15.
Replacement of BEAT with UTPR. The undertaxed profits proposal is estimated to raise $243 billion over 10 years, making it one of the largest revenue raisers in the Budget.?However, this estimate is based on the assumption that other countries do not adopt income inclusion rules, undertaxed profits rules, etc. In reality, the expected revenue will be significantly lower once other countries adopt their own Pillar Two rules.
As a practical matter, the proposed change potentially would be quite burdensome, as taxpayers would be required to follow and compare multiple sets of regulatory rules apart from the federal tax code, maintain complex computations and maintain sufficient records. Further, this increases not only administrative burdens but also the potential uncertainty involved in evaluating federal tax positions.
The UTPR deduction disallowance would apply only after applying the other deduction disallowance provisions in the Code (e.g., IRC Section 163(j)), and would apply pro rata to all other allowable deductions. To the extent that the UTPR disallowance for a tax year exceeds the aggregate deductions otherwise allowable to the taxpayer for that year, the excess would be carried forward indefinitely until an equivalent amount of deductions is disallowed in future years.
Minimum income tax on wealthiest taxpayers.This provision is unprecedented in proposing to tax capital gains before a recognition event. It is a stark departure from the present tax system of taxing only recognized gains.
Recapture of gain on IRS Section 1250 property. Under present law, gain on the sale of section 1250 property held for more than one year generally is treated as ordinary income to the extent of the excess of depreciation claimed over straight-line depreciation and any remaining gain is treated as long-term capital gain under IRC Section 1231. Additionally, for corporations, the amount treated as ordinary income on the sale of section 1250 property generally is increased by 20% of the additional amount that would be treated as ordinary income if the property were subject to recapture under the rules of Section 1245 property pursuant to Section 291(a)(1). If enacted, the proposal would increase taxes for owners of IRC Section 1250 property by eliminating the current capital gains treatment for certain gains on the disposition of IRC Section 1250 property. Instead, any gain on IRC Section 1250 property held for more than one year would be treated as ordinary income to the extent of the total, cumulative depreciation deductions taken after the proposal goes into effect.
Nonrecognition rules for securities loans of actively traded digital assets: The proposal represents Treasury's acknowledgement that (1) there is a rapidly growing market for digital asset liquidity, (2) taxpayers need tax guidance on these transactions, and (3) certain transactions involving digital assets may be analogous to those described in the securities lending rules of IRC Section 1058. The application of securities lending rules would be well-received by taxpayers who have long argued for non-recognition treatment for these transactions. Taxpayers participating in digital asset lending arrangements should pay close attention to any future developments around this proposal.
Mark-to-market rules for actively traded digital assets. Mark-to-market accounting generally provides a clear reflection of income for assets that are traded in established markets. For market-valued assets, mark-to-market accounting imposes few burdens and offers few opportunities for manipulation. Exchange-traded assets typically have reliably determinable values if they are actively traded. While the proposal would provide some clarity around application of the mark-to-market rules to certain taxpayers and digital assets, taxpayers qualifying as dealers or traders in digital assets will want to consider the administrative feasibility of tracking activity for such accounting method and the volume of their transactions before adopting the method.
For financial accounting purposes, taxpayers may be required to mark certain assets to market, including at year end. To the extent financial accounting valuations are consistent with the determination of fair market value for tax purposes, allowing taxpayers to use their financial accounting valuations for tax purposes may reduce tax compliance costs
Fixed indemnity health policies. Employers increasingly offer employees insured fixed indemnity benefits, which provide the employees with a fixed payment upon a specified medical event, instead of, or in addition to, traditional medical expense-based coverage. Employers typically claim a deduction from income taxes for the full cost of the fixed indemnity coverage and do not include the cost of these benefits when calculating income tax withholding and FICA and FUTA taxes on employees' compensation income. As a result, employers who fail to track expenses generally fail to include the amount of any fixed payment in excess of actual medical expenses in the employees' gross income for income tax purposes or in compensation (or wages) for FICA and FUTA tax purposes. This leads to an underpayment of taxes owed; the proposal is intended to remedy any underreporting in this context.
On-demand pay arrangements. It is unlikely that many employers or third-party payors treat employees with access to on-demand pay arrangements as being in constructive receipt of their wages because it would be a significant financial and administrative burden on the employers or third-party payors to configure their payroll systems and make payroll deposits on a daily basis. As a result, wages are treated as paid on the regularly scheduled pay dates, rather than when the wages are constructively received by the employees. The proposed statutory modifications are intended to provide certainty and uniformity for taxpayers for on-demand pay and would establish a uniform and administrable system for the IRS. Without legislation, on-demand pay arrangements will continue to proliferate with some taxpayers taking aggressive tax positions on the timing of the wage payment for employment tax purposes and the timing of the withholding and deposit of the employment taxes.