The Situation: On August 16, 2022, President Biden signed the Inflation Reduction Act of 2022 into law. The Act establishes a new 15% corporate minimum tax (the "CMT") on large U.S. corporations (generally those with pre-tax earnings in excess of $1 billion) and U.S. subsidiaries and branches of certain large foreign-parented corporate groups.
The Result: For tax years beginning after December 31, 2022, corporations subject to the CMT will owe additional tax if they do not otherwise pay taxes equal to at least 15% of their pre-tax financial statement income as adjusted by the Act.
Looking Ahead: The CMT is a new alternative minimum tax imposed on income that large corporations report on their financial statements (book or financial statement income) with some significant deviations in calculating the income. The CMT targets corporations that pay lower U.S. tax on foreign earnings, take advantage of tax incentives, use tax attributes like NOLs, and utilize expenses that are not deductible in the same way on financial statements resulting in book/tax differences, all of which lower the current U.S. federal tax burden. The CMT's tax base has significant deviations from financial statement principles, however, which will help some taxpayers and harm others. For corporations subject to the CMT, the compliance burden will be substantial but because the CMT provides for an unlimited CMT credit carryforward, the impact on a taxpayer's total book tax expense may not be significant.
Who is Subject to the CMT?
The CMT only applies to very large corporations. These "Applicable Corporations" are: (i) U.S. corporations with average annual adjusted financial statement income ("AFSI") in excess of $1 billion measured on a consolidated basis using a three-year average; (ii) U.S. corporations with average annual AFSI of $100 million or more, measured on a consolidated basis using a three-year average, that are members of foreign parented groups with average annual AFSI in excess of $1 billion, again measured using a three-year average; and (iii) foreign corporations that meet the above-income thresholds taking into account any U.S. branches as if each were a U.S. corporation. Annual AFSI is generally net income for financial statement (book) purposes but taking into account numerous modifications, some of which are discussed below. The book net income is generally based on the corporation's applicable financial statement, which in most cases will be a Form 10-K or a similar foreign financial statement.
Private equity funds have a favorable exemption. The CMT apparently does not apply to separate, otherwise unrelated, corporations that do not individually satisfy the pre-tax book income threshold but are under the control of a single investment fund. The rules are intended to prevent aggregating the income of a private equity fund's separate portfolio companies.
The CMT does not apply to S corporations, real estate investment trusts, or regulated investment companies.
Once a taxpayer is an Applicable Corporation, it remains an Applicable Corporation until it has a specified number of consecutive tax years (to be determined by the Secretary of the Treasury) including the most recent tax year, where the corporation does not meet the average annual AFSI threshold and the Secretary determines that it is not appropriate to continue to treat the corporation as an Applicable Corporation. We expect future guidance to include safe harbor exemptions from Applicable Corporation status to avoid the need to obtain individualized determinations in all cases.
Modifications to Book Income
"Adjusted financial statement income" or AFSI is a new tax law concept. AFSI equals net income as determined under standard accounting principles and modified by adjustments meant to address various policy concerns.
Depreciation and Depletion. In determining AFSI, the Act requires taxpayers to deduct tax depreciation (as opposed to book depreciation) for tangible property. This reflects a concern that the CMT would otherwise harm companies in capital-intensive industries like manufacturing, utilities, telecommunications, and energy, which typically rely on accelerated tax depreciation rules to decrease current tax. However, this is not necessarily a "helpful" modification because a company's book depreciation may actually exceed tax depreciation, especially if the company has taken accelerated tax depreciation in prior years. In addition, the Act does not expressly extend tax deductibility to depletion, which is a form of depreciation for taxpayers extracting natural resources like oil, gas, and minerals. These taxpayers use book accounting principles to determine depletion (rather than the tax depletion rules) computing AFSI. This may be an oversight that should be corrected or clarified.
Amortization. In a provision favorable to wireless telecommunication carriers, the Act requires taxpayers to amortize purchased wireless spectrum under the tax (not book) rules. This benefits wireless telecommunication carriers that have made considerable investments in wireless spectrum. Significantly, the Act does not require similar modifications for goodwill and other intangible assets which means that book amortization (which is usually zero in the case of goodwill) must be used to compute AFSI.
State and Local Income Taxes. The Act requires taxpayers to deduct state and local income tax expenses in determining AFSI. This might be a surprise to anyone familiar with standard accounting principles that generally would add back these expenses in computing pre-tax book income. Regulatory guidance is authorized, however, to address current and deferred taxes, and the government may exercise this authority to limit deductions at least for deferred state and local income taxes that are not usually deducted for federal income tax purposes.
CFC Losses. Determining the amount of income from CFCs included in AFSI is a three-step process. First, all CFC income is eliminated from consolidated AFSI to the extent such income is included in AFSI. Second, for each CFC, AFSI is recomputed taking into account all the adjustments otherwise required to be made in determining AFSI. Third, while the Act is unclear, it appears that the taxpayer must compute the sum of the separate adjusted financial statement income or loss of each CFC, and if this sum is a net positive adjustment, the amount is added back to the consolidated AFSI, and if the sum is a net negative adjustment, no adjustment is made, but the net loss is carried forward to reduce CFC income in future years.
Defined Benefit Plans. AFSI excludes any income, cost, or expense related to defined benefit plans included in an applicable financial statement. After excluding such book amounts, AFSI is increased by taxable income items of the corporation and decreased by tax deductible items of the corporation with respect to defined benefit plans. This adjustment only applies, however, for calculating CMT and not for determining whether a corporation is an Applicable Corporation. As a result, more companies may be Applicable Corporations because of pension gains in 2020 and 2021 from the recent bull market.
And the Rest. Other adjustments and rules applicable when computing AFSI include adjusting for different tax years, certain dividends, partnership income, effectively connected income, disregarded entities, cooperatives, Alaska Native Corporations, direct payment of certain tax credits, mortgage servicing income, tax-exempt entities, reasonable compensation, and any other adjustments that the Secretary deems necessary to carry out the purposes of the CMT.
Attributes Available to Reduce CMT and CMT Carryovers
The CMT increases a taxpayer's tax liability only to the extent that the CMT exceeds regular corporate income tax liability plus the base erosion and anti-abuse tax (BEAT). Some tax attributes are available to reduce CMT.
Net Operating Losses. After making all other required adjustments to AFSI, an Applicable Corporation may offset up to 80% of remaining AFSI with financial statement net operating losses generated in tax years ending after December 31, 2019. This adjustment only applies for calculating CMT and not for determining whether a corporation is an Applicable Corporation.
Foreign Tax Credits. Foreign tax credits are allowed to offset CMT. With regard to CFCs, the foreign tax credit allowed is the lesser of aggregate foreign taxes paid or accrued by all relevant CFCs and taken into account in the applicable financial statement of each CFC or 15% multiplied by the aggregate CFC income included in the Applicable Corporation's AFSI as described above. For taxes paid directly by a U.S. corporation, the foreign tax credit equals the amount of foreign taxes paid or accrued and taken into account in the Applicable Corporation's applicable financial statement. A limited five-year carryover is available for foreign taxes incurred by CFCs in excess of 15% of the underlying foreign income.
General Business Credits. A limited general business credit is also available to offset CMT in an amount up to approximately 75% of the sum of the regular tax and the CMT.
CMT Credit Carryforwards. An Applicable Corporation that pays the CMT receives an indefinite CMT carryforward against future regular tax liability to the extent in excess of CMT.
Consequences for Tax Accounting and Compliance
For U.S. multinationals who only recently have addressed the 2017 Tax Cuts and Jobs Act and the corresponding restructuring necessitated by it, the new legislation will add yet another layer of complexity and impose substantial compliance burdens on companies within its scope.
In particular, the CMT's effect on financial statements is not immediately clear. Helpfully, the Act provides for a tax credit for any CMT paid, which may be carried forward indefinitely to apply against regular income tax liability in future years. In theory, this could help characterize the CMT as a timing difference for financial accounting purposes, limiting the adverse impact on after-tax income. Depending on their circumstances, however, companies may be required to record a valuation allowance against their CMT tax credit carryforward resulting in a reduction in book earnings.
We also note that, while the CMT is putatively a 15% minimum tax, it does not comply with the standards outlined by the Organisation for Economic Co-operation and Development ("OECD") for the Global Anti-Base Erosion Model Rules (Pillar Two). For instance, the CMT's income thresholds are much higher and the CMT is not a country-by-country "top up" tax. If U.S. policymakers were to adopt Pillar Two, it may require enactment of yet another corporate minimum tax (in addition to GILTI and the CMT) or modifications to the current GILTI and CMT regimes.
Four Key Takeaways
- The CMT is assessed on adjusted financial statement income which departs from standard accounting principles in significant ways.
- A taxpayer may not be able to reduce the CMT tax base by foreign subsidiary losses.
- The accounting treatment of the CMT is unclear. For some companies, the CMT may result in a timing difference for financial accounting purposes or result in an increased effective tax rate if CMT tax credit carryforwards are unlikely to be utilized.
- The CMT does not comply with the OECD's proposed global minimum tax (Pillar Two).Future compliance with Pillar Two, if sought, will require yet another corporate minimum tax or modification to the GILTI and CMT regimes.