On December 22, 2017, the President signed into law the Tax Cuts and Jobs Act (the TCJA), the most substantial overhaul of the Internal Revenue Code since 1986. The TCJA significantly changes how the US taxes individuals, partnerships, and domestic and multinational businesses. Because of its breadth, implementing the TCJA provides companies with an abundance of both challenges and opportunities.
Given the timing of the enactment of the TCJA, companies face immediate challenges implementing the changes driven by the new law. The TCJA contains a number of provisions that could benefit from clarifying administrative guidance. Moreover, certain provisions require technical corrections to clarify their application. Unfortunately, robust administrative guidance is unlikely to be issued quickly, and the timing of technical corrections is even more uncertain. As a result, companies must address the challenges of transitioning to the new tax law while uncertainty remains concerning the interpretation of some of its provisions. This legal alert provides guidance regarding minimizing the risks associated with implementing the new tax law while taking advantage of the opportunities presented.
The combination of expiring provisions coupled with newly enacted provisions creates unique tax planning opportunities. At a minimum, companies will want to consider implementation choices that maximize the time value of money by utilizing ordinary procedural tools to defer income and accelerate deductions. Companies will also want to consider using existing procedural tools to take advantage of unique and limited opportunities presented by the TCJA. Moreover, when decision-making is complicated by inherent uncertainties in the new tax law, companies will want to engage in best practices to define and document their decision-making process to minimize future controversy. Thus, because it is difficult to assess the risks of implementing the TCJA in the absence of guidance, this alert discusses the importance of employing good tax controversy practices to minimize exposure to a potential future challenge by the Internal Revenue Service.
The following table identifies familiar procedural tools and the distinctive attributes of each. Implementation of the TCJA is not pro forma, and thus, depending on specific facts and circumstances, one or more of these tools may be available to enhance the tax results of implementation and/or minimize future controversy.
Although accounting method changes are available on a prospective basis only, because they are implemented with a Section 481(a) adjustment, accounting method changes may affect amounts taken into account in earlier tax years, including closed years. Note that accounting method changes are limited to items that are recurring in nature and affect the timing of income and expenses, and require IRS consent before the change may be affected. Such consent is available automatically in certain circumstances, which means that the IRS’ required approval has been granted. Automatic accounting method changes available with 2017 corporate returns are described in Rev. Proc. 2017-30, 2017-18 I.R.B. 1131 (Apr. 19, 2017).
In contrast, an amended return may be used to correct a mistake made in an originally filed tax return. An amended return may also be used to take advantage of a retroactive statute or IRS procedure. Amended returns serve two purposes: to modify, supplement or supplant the taxpayer’s original return, and to provide the vehicle for a claim for refund. An amended return, unlike an accounting method change, does not require the IRS’ prior approval. Nonetheless, the IRS routinely examines amended returns to ensure that the taxpayer is entitled to a refund claimed in connection with the amended return. Moreover, refunds that exceed the statutory threshold of $2 million ($5 million for C corporations) are also subject to a Joint Committee review process before issuance.
Certain tentative refund claims are permitted with respect to the carryback of a net operating loss (NOL), the carryback of an unused general business credit, the carryback of a net Section 1256 contract loss, or an overpayment of tax due to a claim of right adjustment under Section 1341(b)(1). These tentative claims are filed on a Form 1045, Form 1138 or Form 1139, and are often referred to as “quickie refunds.” The IRS has 90 days to review the claimed refund. Quickie refunds are available with respect to an amended or original return followed by a tentative carryback refund claim. During the 90-day timeframe, the IRS determines the amount of overpayment and then applies credits or refunds the overpayment. Of course, a quickie refund is only a tentative adjustment in the taxpayer’s tax liability. Any payment of a quickie refund does not conclusively resolve the tax liability for the year creating the carryback credit or refund. Further, the allowance of a tentative claim does not bar the IRS from reducing the amount by unassessed or disputed liabilities for the years covered by the claim. In addition, the examination of returns for all open years for possible deficiencies may result in adjustments that exceed the amount of any refund.
Using Procedural Tools to Maximize Opportunities under the TCJA
Accounting method changes should be considered to take full advantage of the TCJA’s reduced corporate tax rate from 35% to 21% for years beginning after December 31, 2017. Taxpayer-favorable accounting method changes that are available on an automatic basis (for example, changes involving tangible property, depreciation, customer rebates and allowances, accrued compensation, deducting prepaid liabilities) may be filed with the Federal income tax return to accelerate deductions into 2017 while the tax rates are higher. Although accounting method changes generally only produce a temporary benefit due to the rate change, accounting method changes filed with 2017 returns produce permanent benefits due to the corporate rate change. Rev. Proc. 2017-30 provides a list of automatic accounting method changes that may be considered for inclusion with a 2017 Federal income tax return.
Accounting period changes are available automatically under Rev. Proc. 2006-45, 2006-2 C.B. 851. Section 442 generally requires the Commissioner’s advance consent when an accounting period is changed; however, for more than 15 years, the IRS has granted automatic consent when certain conditions are met. See generally Rev. Proc. 2006-45. Automatic accounting period changes are effective as of the beginning of the tax year even though the paperwork documenting the change is not due until the Federal income tax return is filed.
With other tax law changes, accounting period changes have been used to delay the effective date of an unfavorable law change, accelerate expense recognition, defer income recognition, or offset profits available through an expiring net operating loss. Recently, the IRS issued Rev. Proc. 2018-17, 2018-9 I.R.B. (Feb. 13, 2018), which limits the ability of certain specified foreign corporations to change its accounting period automatically when the change results in the avoidance, reduction, or delay of the transition tax. Rev. Proc. 2018-17 affects a limited group of taxpayers, however, it should be considered with any anticipated accounting period changes with respect to the transition tax.
In addition, the TCJA makes two important changes to the net operating loss provisions. Specifically, the deductibility of a taxpayer’s NOLs are limited to 80% of the taxpayer’s taxable income for losses arising in taxable years beginning after December 31, 2017, and NOL carrybacks are essentially eliminated (exceptions for two-year carrybacks for farms and certain insurance companies) for losses arising in taxable years ending after December 31, 2017. As a result of these changes, companies should fully evaluate any NOLs currently captured on their balance sheets as deferred tax assets and pay attention to the timing of such losses, because the changes vary depending on the type and timing of such losses. Further, companies will want to take advantage of the NOL carryback provisions for taxable years ending on or before December 31, 2017. Although NOLs may be carried forward indefinitely, with the new 20% haircut, NOLs are relatively more valuable currently than they will be in future years. Companies should evaluate whether amended returns are required to fully utilize losses in open years. Also, depending on the taxpayer’s position, a carryback claim may be required to take advantage of carryback potential.
The TCJA repeals the deduction for domestic production activities provided in Section 199 for taxable years beginning after December 31, 2017. Currently, Section 199 allows taxpayers to claim a deduction equal to 9% of qualified production activities income. Companies eligible for this provision may want to reevaluate their supply chain as domestic production may not be as valuable to their bottom line as before. In addition, Section 199 may be claimed for any open years beginning before January 1, 2018, which means that companies within the scope of the provision should consider filing amended returns to take full advantage of the provision.
The full expensing provision of the TCJA expanded existing bonus depreciation to 100%, and it permits the deduction of the cost of “qualified property” acquired and placed in service after September 27, 2017, and before January 1, 2023. Companies will want to review all acquisitions between September 27, 2017, and December 31, 2017, to confirm that any acquired property is considered qualified property available for full expensing during this small window period when the 35% corporate rate overlaps with the full expensing provision. Because the TCJA allows companies to take advantage of the bonus depreciation for any property acquired by year-end, there may be an ability to carry back the NOLs to prior tax years. Additionally, the new provision also allows full expensing for used property. As a result, full expensing is available for corporate transactions characterized as asset acquisitions (i.e., Section 338) to the extent that the acquisition includes qualified property. For this purpose, it may be possible to allocate capitalized costs to the adjusted basis of qualified property subject to the full expensing provisions. Therefore, otherwise capitalized costs incurred in asset transactions may be eligible for immediate expensing depending on an evaluation of bonus depreciation provisions, tangible property regulations and a transaction cost analysis.
Implementing The TCJA While There Is Ambiguity Regarding Application
Companies face additional challenges in implementing newly enacted legislation the size and scope of the TCJA, especially when ambiguities remain regarding its application. The following examples demonstrate uncertainties that companies face in implementing the TCJA.
For example, companies must evaluate how to properly define and apply the term “trade or business,” which is used throughout the TCJA. One such instance that is causing certain taxpayers concern is the use of “real property trade or business” in the interest expense limitation provisions under Section 163(j). The TCJA allows any “real property trade or business” to exempt itself from the interest expense limitations under Section 163(j) on the condition that such trade or business is also ineligible for the full expensing provisions under Section 168(k). Unfortunately, the IRS has acknowledged there is not a clear answer regarding how to apply the definition of “real property trade or business” for purposes of Section 163(j), and this ambiguity is becoming increasingly critical as many of these trades or businesses have partners that must file estimated tax payments in the near future. Although the IRS has stated publicly this is a priority item under consideration, there is no explicit deadline for expected guidance, and taxpayers must analyze this ambiguous term in the TCJA that could have material impact on estimated tax payments as well as underlying tax liability.
Further, companies with “qualified improvement property” (or QIP) face uncertainty as a result of inconsistency between the statute and Conference Report. Under current law, building improvements are generally depreciated over 39 years; however, certain real property improvements receive an accelerated 15-year recovery. Section 168(e)(3)(E) provided the following three classes of property: (i) qualified leasehold improvements (i.e., improvements made to the interior of a nonresidential building, pursuant to a lease between unrelated parties, with the improvement made more than three years after the building was first placed in service); (ii) qualified retail improvement property (i.e., improvement made to the interior of a nonresidential building, which is used in a retail or other business, and the improvement is made more than three years after the building was first placed in service); and (iii) qualified restaurant property (building or building improvement with more than 50% of square footage dedicated to preparing and serving meals). QIP was also provided with the shortened 15-year recovery period as part of the PATH Act. See Protecting Americans from Tax Hikes Act of 2015 (the PATH Act), which was enacted on December 18, 2015.
In connection with the TCJA, there was an effort to provide conforming tax treatment and consolidate these types of real property into a single term, QIP. As part of the TCJA, QIP was moved from Section 168(k), which addresses bonus depreciation, to Section 168(e). Unfortunately, however, there were no amendments to provide 15-year recovery for QIP. Additionally, although full expensing under Section 168(k)(2) is available to all property with a useful life of 20 years or less, QIP is also excluded from full expensing. The Joint Explanatory Statement (Conference Report) provides that QIP placed in service after December 31, 2017, would be eligible for 15-year MACRS depreciation. See Conference Report at p. 205.
Existing rules regarding qualified leasehold improvement property, qualified retail improvement property and qualified restaurant property remain effective through December 31, 2017, and allow 15-year recovery to the extent the property was acquired and placed in service by December 31, 2017. Qualified leasehold improvement property and qualified retail improvement property are generally eligible for 50% bonus depreciation to the extent acquired and placed in service by September 27, 2017, and generally eligible for 100% bonus depreciation if acquired and placed in service after September 27, 2017, through December 31, 2017. Qualified restaurant property is generally eligible for 50% bonus depreciation provided that it also meets the definition of QIP. Due to differences in the effective date of Section 168, and moving QIP from Section 168(k) to Section 168(e), there is no bonus-eligible qualified restaurant property for property acquired after September 27, 2017, through December 31, 2017.
The government has announced that absent technical corrections, the tax treatment of QIP cannot be clarified administratively. Consistent with the Conference Report and in anticipation of technical corrections, certain companies may choose to fully expense qualified restaurant property acquired and placed in service after September 27, 2017. Full expensing may be claimed to reduce tax liability or even create or expand losses so that a carryback claim would be possible prior to the TCJA changes to the NOL provisions. Alternatively, companies may also seek 15-year recovery for QIP acquired and placed in service after December 31, 2017. It is not clear how the government will treat these situations and any company taking one of these positions should be prepared for controversy.
Similarly, some companies have already made, or have put in place operational changes in anticipation of making, an accounting period change. As noted, with other law changes, accounting period changes have been available to defer implementation. Nonetheless, the Conference Report language cautioned, “conferees are also aware that certain taxpayers may have engaged in tax strategies designed to reduce the amount of post-1986 earnings and profits in order to decrease the amount of the inclusion required under this provision. Such tax strategies may include a change in entity classification, accounting method, and taxable year . . . .” H.R. Rep. No. 115-466, at 619 (2017). Consistent with the directive, the IRS issued Rev. Proc. 2018-17 prohibiting accounting period changes by certain specified foreign corporations owned by US shareholders subject to the new transition tax. Absent this guidance, a Section 965 CFC with a taxable year ending on December 31, 2017, could have avoided the purposes of Section 965 for 11 months by changing its taxable year-end to November 30.
Thus, subsequent to the close of 2017, certain automatic accounting period changes were prohibited. Companies that either have already filed such a change, or intended to file such a change and made operational changes in anticipation of effecting a change during 2017, have been notified that the change is not available, and must consider how to ameliorate future controversy. Even though these changes have been prohibited for CFCs, it is unclear whether US shareholders in a Section 965 CFC are similarly prohibited from making such a change, and risk should be evaluated if an automatic accounting period is considered. In addition, companies considering other accounting period changes should be aware that additional administrative guidance could be issued limiting the availability of other accounting period changes.
These example are just a few of many issues that companies implementing the TCJA must address while there is ambiguity, either because of a lack of administrative guidance or uncertainty about whether or when technical corrections will be enacted. The unfortunate consequence of these situations is that if no action is taken, a company may lose a valuable right. Because resolution is not likely for some time, questions arise regarding what steps should be taken to ensure that best practices are followed.
Minimizing Tax Controversy Risks with Pro-Active Implementation Processes
Interpreting and implementing new tax law can be a challenging exercise under the best of circumstances. With respect to the TCJA, some of its provisions are explicitly targeted at correcting perceived abuses. Thus, it is anticipated that the IRS will conduct examinations to ensure that the provisions are being correctly implemented and followed. While it is always a good practice to make sure that the tax return file is “audit ready,” this is particularly true with respect to implementation of the TCJA. In this case, there will be instances in which implementation of a provision of the TCJA is hampered by gaps in guidance or perceived ambiguities in the statute. When guidance on point is lacking, companies will need to develop a reasoned approach to decision-making using the tools that are available, apply the approach consistently, and document the analysis and decisions made.
Keys to Developing a Reasoned Approach to Decision-Making
When addressing implementation issues, a company should first analyze the practical choices available and the existing authority. Any analysis should include a careful review of the origin and content of the language of the statute. If the statute is clear on its face, a court will likely apply the statute as written regardless of whether the consequences are expected or unexpected, welcome or unwelcome. On the other hand, when there are gaps or ambiguities in the statutory language or framework, a court will generally look beyond the language of the statute to determine how to apply the statute. In that event, companies will want to identify and analyze external sources of information in assessing how to apply the statute to their specific circumstances. With respect to the application of QIP, there is explicit legislative intent regarding the intended scope of the statute. There are likely other sources articulating the anticipated result to support how the statute should apply to specific circumstances. Note, however, that the US Supreme Court has stated that “[i]f Congress enacted into law something different from what it intended, then it should amend the statute to conform to its intent.” United States v. Granderson, 511 U.S. 39, 68 (1994).
For the relatively rare situation in which adhering to the plain language of the statute yields absurd or unconstitutional results, further inquiry is warranted. Although the “anti-absurdity” canon of statutory construction is rarely invoked by courts these days, it is still the case that a statute will be interpreted to avoid constitutional problems. Thus, for those situations in which adhering to the plain language of the statute would lead to absurd or unconstitutional results, a company may wish to take more proactive steps to establish that point in the public record. These steps would at a minimum serve to encourage the issuance of guidance or the pursuit of a technical correction. Moreover, a contemporaneous record of the difficulties companies are facing in establishing a specific tax position absent guidance on point may prove useful in the event of a future IRS challenge to the position ultimately adopted by a company.
1. Establish, Document and Execute a Decision-Making Process
As an initial matter, a company should establish and document a decision-making process to be followed when implementing provisions of the TCJA. Such a process should describe the steps that the company will take, the stakeholders to be included in the discussions, and the roles and responsibilities of the participants in the decision-making process. Care should be taken to preserve applicable privileges and protections, such as the attorney-client and Section 7525 privileges, and attorney work product protection. If appropriate, implementation of provisions of the TCJA that have material implications on business operations should be coordinated with the General Counsel. Keep in mind that in order to maintain the privileges and protections that apply to confidential communications with attorneys, a company may need to implement protective measures in order to ensure that the privileges and protections are not inadvertently waived.
With respect to addressing substantive concerns, a company should consult its internal and external tax advisors to develop a position that is supported by some measure of authority, even if that authority is only explicitly applicable to an analogous set of circumstances. In essence, the company should use its best efforts to gather all of the information that will be helpful to its decision, and consider and discuss that information with advisors and stakeholders before making a decision. For companies that have made, or intend to file, an accounting period change potentially precluded by Rev. Proc. 2018-17, it will be important to establish that there has been full compliance with the automatic approval requirements, and that there are legal arguments to support the change. Because success will require unique circumstances to support the taxpayer’s change, companies will need to show entitlement to administrative relief as well as a compelling rationale for the change.
Contemporaneous support for each tax position should be well documented in order to substantiate the corporate decision to take the position. For example, a taxpayer taking the position that certain activities may be considered QIP should document other corollary positions supported by legislative history and supported by technical corrections and/or subsequent administrative guidance.
2. Ensure that Decisions Are Consistently Reflected Throughout Corporate Operations
Once the proper analysis has been performed, and a discussion among the stakeholders yields a course of action to be taken with respect to implementation, the company should ensure that the course of action is, in fact, followed. For example, assuming again that the company is taking the position that certain improvements are properly characterized as QIP, if the company further determines such QIP is eligible for bonus depreciation or 15-year recovery as opposed to a 39-year life suggested by the TCJA, the company’s depreciation system and all records should strictly conform to the position taken. The company should fully document its business processes and non-tax analyses consistent with the technical recommendations as well. Moreover, there should be transparency and robust internal communication with business unit stakeholders concerning the analysis performed and the support for the technical position taken.
3. Properly Document the Process, Analysis, Decision and Implementation in the Tax Department’s Files
Companies should prepare and maintain an “audit ready” file for each of the tax positions taken in connection with implementing the TCJA. These files should document the consistent internal process employed to reach decisions, as well as contain the contemporaneous rationale and support for those decisions. Moreover, the files should document the operational steps taken to implement the decisions, including step plans, board resolutions, corporate minutes, relevant email, etc.
Subsequent to the enactment of the TCJA, companies are facing an abundance of challenges in implementing the changes driven by the new law. The number of provisions in the TCJA that require clarifying administrative guidance or technical correction, coupled with realistic expectations concerning the timing of guidance or technical corrections, means that companies will have to make choices in implementing the new law notwithstanding the fact that uncertainty remains. When reviewing their interpretation and application of the TCJA, companies should keep in mind the number of procedural tools that may be utilized to implement the new law, i.e., changes in accounting methods, changes in accounting periods, amended returns, and carryback claims. To ensure that such implementation can withstand subsequent scrutiny, companies should also ensure that they are fully documenting their processes, their analyses, and their support for the technical positions being taken. Provided that this documentation is available in an “audit-ready” file, companies will be armed with the resources needed to address any issues or questions that may arise at Exam or otherwise.