On September 27, 2017, a group of Congressional leaders and White House officials, referred to as the Big Six, released their preliminary plans for tax reform, entitled United Framework for Fixing Our Broken Tax Code (the Framework). The Framework proposes significant changes to the federal tax code, which includes reductions to both individual and corporate tax rates, while eliminating a number of widely used exemptions and deductions.
Among the proposed changes to the current tax code, the Framework proposes modifications that affect a taxpayer’s accounting methods and tax accounting provisions. For example, the Framework includes a five-year window of immediate expensing of newly acquired assets and eliminates most business credits. Further, the Framework envisions a corporate tax rate reduction as well as repatriation of accumulated foreign earnings and profits (E&P). These and other elements of the Framework present potential opportunities to implement accounting method changes and adopt other changes in business practices with a view toward realizing permanent tax benefits.
This alert describes the proposals that affect accounting methods and includes recommendations for taxpayers to consider as the Framework is incorporated into legislation.
Five-Year Window of Immediate Expensing of Newly Acquired Assets
The Framework allows businesses to immediately expense or “write off” the cost of new investments in depreciable assets, other than structures, which are acquired after September 27, 2017, with full immediate recovery lasting for at least five years. The immediate expensing provision was included to spur economic growth and greater investment in the American economy, particularly in the manufacturing sector.
This proposal is similar to bonus depreciation, provided for by section 168(k), which was first enacted in 2001 and modified periodically thereafter. These earlier provisions allowed 100%, 50%, 40% and 30% bonus depreciation for a range of capital assets. The five-year window appears budget driven; however, there is a history of Congressional tinkering with depreciation’s terms and conditions. Because the current bonus depreciation provisions are scheduled to end in 2019, if enacted, capital-intensive businesses will appreciate the immediate cost recovery for machinery, equipment and other depreciable assets. In addition, compliance burdens will generally be reduced since companies will be able to focus less on classifying and segregating assets into their proper depreciable lives. Regulated industries, however, will once again face the unfortunate challenge of addressing the treatment of fixed assets in a changing tax environment.
If immediate expensing is enacted, it will be important to review the tax treatment of all current fixed assets to ensure that all available depreciation has been claimed for earlier tax years using the most favorable methods. Favorable fixed asset treatment coupled with the expected tax rate changes may potentially generate a permanent tax benefit.
Elimination of Most Business Credits and Deductions
As the Framework points out, because of the recommended reduction in the corporate tax rate, most business credits and deductions will not be “necessary” and should be “repealed or restricted.” The Framework notes that the repeal would not include credits for low-income housing and section 41 research and development (R&D) costs, concluding that both credits have “proven to be effective in promoting policy goals important in the American economy.”
The Framework suggests a very different policy for credits. Historically, tax credits have been used to incentivize taxpayer behavior. The Framework seems to suggest that such behavior will continue with a reduced tax rate and without requisite credits. It will be interesting to see, for example, whether energy transactions are completed at the same pace without specialized credits available to support the transaction.
With the repeal of most credits other than the section 41 R&D credit, taxpayers should anticipate greater scrutiny from the IRS and examining agents with these credits. One way to avoid potential scrutiny may be to use the safe harbor announced September 11, 2017, by the IRS LB&I division. Under the safe harbor, an adjusted amount of R&D costs can be determined to be qualified research expenses (QREs) eligible for the section 41 credit, and LB&I examiners are directed not to challenge these amounts of QREs. Among the many options available to taxpayers to strengthen support for claimed deductions and credits, this safe harbor should be considered.
The Framework also specifically identifies the section 199 domestic production deduction as no longer necessary due to “domestic manufacturers [seeing] the lowest marginal rates in almost 80 years.” In light of this proposed elimination, taxpayers may want to consider reviewing previous section 199 deductions to confirm that all available deductions have been taken in the appropriate tax year. Further, because the Framework calls for a repeal of most credit provisions, taxpayers should review all credits that are being used currently or those that have been used historically to evaluate the effect of anticipated repeal.
Reduction in Corporate and Pass-Through Tax Rates
The Framework calls for a reduction in the top corporate tax rate from 35% to 20%. Additionally, the Framework aims to reduce the rate for pass-through entities to 25%, although it is important to clarify that such reduction is intended to apply to the “business income of small and family-owned businesses” operating as pass-through entities, thereby, potentially carving out larger, publicly traded and professional partnerships (accountants, lawyers and doctors) from the reduced rate.
The anticipated rate reductions should serve as a signal to corporate and pass-through businesses to consider whether it may be possible to secure a permanent tax benefit from the lower rates. Although accounting method changes generally provide a temporary benefit, to the extent that income is recognized in a tax year subsequent to the rate reductions, or if deductions can be accelerated into a tax year when the tax rates are higher, a permanent benefit results. Moreover, any accounting method change that offers permanent tax savings is one that is taxpayer-favorable (e.g., the deferral method for advance payments; deferral of income related to unbilled receivables; accelerating deductions related to software development costs; IBNR liabilities, rebates and allowances, etc.). Also, a number of income and expense items can be changed without a method change, for example, with a change in contract provisions or a change in business practice (prepaying expenses, accelerating bonus payments), which would produce permanent benefit.
Importantly, many accounting method changes are available automatically, i.e., such accounting method changes could be filed with a federal income tax return without obtaining advance consent from the IRS. If tax reform is enacted before the end of 2017 with a January 1, 2018, effective date as the Republican leaders hope, an automatic accounting method change could be filed with a tax return for 2017 (effective as of the beginning of the tax year). This return would be due by the extended due date for filing 2017 returns. Any non-automatic method changes must be filed with the IRS by the end of the taxpayer’s year.
In light of the proposed change in tax rates, another important consideration is the application of section 1341. While the amount and timing of earned income is generally known, in certain circumstances a taxpayer reports certain amounts of income and then subsequently must return such amounts. When tax rates remain unchanged, the deduction available to a taxpayer related to the refunded amount fully offsets the previously recognized income; when tax rates decrease, however, the deduction does not fully offset the taxes previously paid. If satisfying certain requirements, section 1341 may be used to calculate the tax due based on the rates applicable when the income was initially reported. Section 1341 should be considered by taxpayers in light of the proposed reduction to the corporate and pass-through tax rates.
Because a rate reduction seems possible, it is important to consider whether particular accounting methods or other changes should be considered to take advantage of any rate changes.
The Framework also provides for a transition to a territorial system with a 100% exemption for dividends from foreign subsidiaries in which the US parent owns at least a 10% stake in the subsidiary. In order to facilitate the transition to this system, the Framework treats foreign E&P that accumulated overseas under the old system as repatriated. Accumulated foreign E&P held in illiquid assets is expected to be subject to a lower tax rate than foreign E&P held in cash or cash equivalents, with payment of any tax liability spread over several years.
In light of this focus on taxing accumulated E&P of foreign subsidiaries, businesses should evaluate the accounting methods of all foreign subsidiaries to determine whether an accounting method change may be available to reduce their foreign subsidiaries’ E&P. Based on the current attention to foreign holdings, this is an area of the Framework which will be highly scrutinized; therefore, taxpayers should approach any method change opportunities in this context cautiously and maximize any opportunity to secure audit protection with respect to any such accounting method changes.