On August 7, 2022, the US Senate passed the Inflation Reduction Act of 2022 (the Act), a budget reconciliation bill recently introduced by Senate Majority Leader Chuck Schumer (D-NY) and Senator Joe Manchin (D-WV). The bill dropped most of the proposed tax-related changes in the Build Back Better Act of 2022 that passed the US House of Representatives last November and in the US Department of the Treasury’s (Treasury) Fiscal Year 2022 budget and Green Book. The bill does, however, feature a new 15% minimum tax on corporations with book profits exceeding $1 billion (Book Minimum Tax or BMT), a tax previously proposed by the Biden administration. Having cleared its greatest hurdle in the Senate, the Act, including the Book Minimum Tax, appears very likely to become law.
The Book Minimum Tax would impose on any “applicable corporation” a tax equal to the excess of (1) 15% of the applicable corporation’s adjusted financial statement income for the taxable year, reduced by its “corporate AMT foreign tax credit,” for the taxable year (tentative minimum tax), over (2) its regular tax liability plus any base erosion and anti-abuse tax (BEAT) imposed under section 59A for the taxable year. If enacted, the Book Minimum Tax would be effective for taxable years beginning after December 31, 2022. Taxpayers are generally allowed to credit the BMT paid in a prior year against their regular tax liability for a future year to the extent the regular tax liability exceeds the amount of its tentative minimum tax for the future year.
DEFINITION OF APPLICABLE CORPORATION
“Applicable corporation” means any corporation (excluding S corporations, regulated investment companies and real estate investment trusts) that satisfies the “average annual adjusted financial statement income test” (Book Income Test) for one or more prior taxable years ending after December 31, 2021. A corporation meets the Book Income Test if its average annual adjusted financial statement income for the three-taxable year period ending with the relevant taxable year exceeds $1 billion. For example, a calendar year corporation in 2023 would compute its average annual adjusted financial statement income for the three-year period running from 2020 to 2022 to determine if it exceeds the $1 billion threshold. For this purpose, the annual adjusted financial statement income is determined without adjustment for any negative adjusted financial statement income (financial statement NOL) carried over from a previous year.
A modified Book Income Test is applied to determine applicable corporation status when the corporation in question is a member of a foreign parented multinational group. A foreign parented multinational group is established for this purpose by two or more entities that are included in the same applicable financial statement for a taxable year if: (1) at least one entity is a domestic corporation and another entity is a foreign corporation, and (2) the common parent of such entities is (or is deemed under forthcoming regulations to be) a foreign corporation. For this purpose, a foreign corporation’s US trade or business is treated as a separate domestic corporation wholly owned by the foreign corporation.
Under the modified Book Income Test, a corporation that is a member of a foreign parented multinational group is an applicable corporation if (1) the average annual adjusted financial statement income of the corporation and all foreign members of its foreign parented multinational group for the three-taxable year period ending with the relevant taxable year together exceeds $1 billion; and (2) the corporation’s average annual adjusted financial statement income for the three-taxable year period ending with the relevant taxable year (determined without adjustment for any financial statement NOL carried over from a previous year and after applying aggregation rules, generally described below) is at least $100 million.
Solely for purposes of determining applicable corporation status, all adjusted financial statement income of persons treated as a single employer with a corporation under section 52(a) or (b), with certain modifications, is treated as adjusted financial statement income of such corporation. Thus, income of members of the same controlled group and flow-through entities under common control is generally aggregated for purposes of applying the Book Income Test.
If a corporation has been in existence for less than three taxable years, the Book Income Test is computed based on the period it was in existence instead of the three-year period. In the case of a short taxable year, the income is annualized based on the number of months in the short period.
Once a corporation satisfies the Book Income Test for a taxable year, the corporation will, regardless of its average adjusted financial statement income in subsequent years, continue to be treated as an applicable corporation subject to the Book Minimum Tax unless an exception applies.
EXCEPTIONS TO CONTINUING APPLICABLE CORPORATION STATUS
A corporation may shed its applicable corporation status if it has a change in ownership or does not satisfy the Book Income Test for its current taxable year and a number (to be determined by the Treasury) of consecutive previous taxable years, provided, in either case, that the Treasury also determines that it would be inappropriate to continue to treat the corporation as an applicable corporation. Shedding applicable corporation status does not insulate the corporation from becoming an applicable corporation in a later year if the Book Income Test is satisfied.
COMPUTATION OF ADJUSTED FINANCIAL STATEMENT INCOME
“Adjusted financial statement income” means the pre-tax net income or loss of the taxpayer reported on its applicable financial statement for said taxable year, subject to certain adjustments. The key adjustments are as follows:
- Members of a consolidated group. In the case of a taxpayer that is a member of a consolidated group, the group’s applicable financial statement is treated as the taxpayer’s applicable financial statement. Such group appliable financial statement income is then adjusted to (1) take into account items allocable to members of the consolidated group and (2) exclude income items of any non-member affiliates that are included on the applicable financial statement but not on the consolidated return. However, if the taxpayer receives dividends from a non-member affiliate, or otherwise takes into account income or deductions with respect to the non-member affiliate, the dividends and other amounts are taken into account in computing its adjusted financial statement income.
- Income or loss of flow-through entities. If the taxpayer is a partner in a partnership, only its distributive share of the partnership’s net income or loss is taken into account. If the taxpayer is the sole owner of a disregarded entity, the disregarded entity’s adjusted financial statement income is taken into account.
- Pro rata share of controlled foreign corporation (CFC) income or loss. If the taxpayer is a US shareholder of one or more CFCs, the taxpayer’s adjusted financial statement income is adjusted to take into account its pro rata share of the CFC’s net income or loss set forth on their applicable financial statements (CFC Adjustment). The pro rata share for this purpose is determined under rules similar to section 951(a)(2). In the event a CFC Adjustment is negative for a taxable year, the current year adjusted financial statement income does not take into account such negative CFC Adjustment. Instead, the negative amount is carried forward and may reduce the CFC Adjustment in a succeeding taxable year.
- Effectively connected income for foreign corporations. If the taxpayer is a foreign corporation, the principles of section 882 regarding effectively connected income apply for purposes of determining the foreign corporation’s adjusted financial statement income.
- US federal income taxes and foreign income taxes. US federal income taxes and foreign income taxes are not taken into account in determining a taxpayer’s adjusted financial statement income. The treatment of US and foreign taxes is discussed in further detail below.
- Depreciation deductions. Significantly, the Act allows taxpayers to reduce their adjusted financial statement income by taking into account depreciation deductions with respect to tangible property under section 167, including bonus depreciation. In contrast, taxpayers cannot adjust for amortization deductions under section 197, with a limited exception for certain qualified wireless spectrum used in a telecommunications business. In each case, the amount of depreciation or amortization is adjusted to take into account amounts that are already included in the taxpayer’s applicable financial statement.
The Act also includes specific adjustments to take into account: (1) applicable financial statements that cover a period other than the taxable year; (2) amounts described in section 1382(b) for cooperatives; (3) certain deductions allowed for Alaska Native corporations; (4) elections for direct payment of certain credits under section 48D(d) or section 6417; (5) exclusion of certain mortgage servicing income of a taxpayer other than a regulated investment company; (6) exclusion of book income, cost or expense related to a covered benefit plan that is not taken into account under applicable tax provisions; and (7) exclusion of income derived by tax-exempt entities, other than unrelated trade or business income.
Other than the adjustments described above, a taxpayer’s adjusted financial statement income generally does not take into account other tax provisions. For example, adjusted financial statement income is not adjusted to reflect: (1) limitations on interest expense deductions under section 163(j); (2) limitations on deductions for certain employee remuneration that exceeds $1 million under section 162(m); (3) limitations on loss carryforwards under section 382 or (4) amounts that may be included in taxable income in a period prior to their recognition for book purposes under the all events test or section 451(c).
FOREIGN TAXES AND DIRECT AND INDIRECT FOREIGN TAX CREDITS
Importantly, taxpayers compute their adjusted financial statement income based on their pre-tax income (or loss) without taking into account any US federal income taxes or foreign income, war profits or excess profits taxes (within the meaning of section 901). Thus, US and foreign income taxes on the applicable financial statements of the taxpayer or CFCs, if any, generally are added back when computing adjusted financial statement income. To avoid double taxation, however, the proposed legislation would require the Treasury and the Internal Revenue Service to issue regulations providing that a portion or all of such foreign taxes are not disregarded if the taxpayer elects not to claim any foreign tax credits under sections 901 and 960. Alternatively, under the proposed legislation, a taxpayer that elects to claim foreign tax credits under sections 901 and/or 960 for the taxable year is allowed to tentative minimum tax by its “corporate AMT foreign tax credit” for the taxable year.
“Corporate AMT foreign tax credit” generally equals the sum of (1) foreign taxes paid or accrued by a domestic applicable corporation and taken into account on the domestic applicable corporation’s applicable financial statement (such as withholding taxes, or foreign income taxes on branch income, that would give rise to a section 901 credit); and (2) foreign taxes paid or accrued by the applicable corporation’s CFCs that are taken into account on the applicable financial statement of the CFCs (and therefore included in the applicable corporation’s adjusted financial statement income ratably). Furthermore, the corporate AMT foreign tax credit, with respect to the foreign taxes paid or accrued by the CFCs, is limited to 15% of the applicable corporation’s CFC Adjustment for the taxable year described above. For this purpose, the excess is generally carried forward to the succeeding five years.
Notably, the proposed legislation does not incorporate any limitations under section 904 in determining corporate AMT foreign tax credit. Thus, there are no restrictions on cross-crediting between high-tax and low-tax jurisdictions. The proposal likewise does not include other limitations under section 904, such as limitations related to separate limitation loss and overall domestic loss. Additionally, the indirect corporate AMT foreign tax credit with respect to CFCs is not subject to the “haircut” on credits under section 960(d). By imposing the 15% limitation, however, the Act provides less favorable treatment for foreign taxes paid or accrued by CFCs compared to foreign taxes directly paid by a US taxpayer.
GENERAL BUSINESS CREDITS
Although the BMT limits many tax preference items in the Code, corporations will continue to benefit from the research credit and other general business credits under section 38. The Act includes conforming amendments to section 38(c) which, for many taxpayers, will not limit their use of general business credits. As amended, section 38(c) generally limits the use of such credits to an amount equal to the excess, if any, of the taxpayer’s net income tax over 25% of its net income tax as exceeds $25,000. The taxpayer’s net income tax for this purpose includes its regular tax liability and BMT.
NET OPERATING LOSS
A financial statement NOL for a taxable year is carried forward to the following taxable year. Financial statement NOLs can offset up to 80% of the taxpayer’s adjusted financial statement income, computed without regard to any NOL carryforward, in a subsequent taxable year. Financial statement NOLs may be carried forward indefinitely. As noted above, while a financial statement NOL is taken into account in computing a taxpayer’s adjusted financial statement income, it is disregarded for purposes of applying the Book Income Test in determining applicable corporation status.
For this purpose, financial statement NOL is defined narrowly. It includes only NOLs set forth on applicable financial statements for taxable years ending after December 31, 2019, taking into account modifications for adjusted financial statement income described above and without regard to financial statement NOL carryforward from a prior year. Accordingly, while post-2019 financial statement NOLs may be carried forward indefinitely, all pre-2020 NOLs are disregarded in computing an applicable corporation’s adjusted financial statement income under the proposed legislation.
CREDIT FOR PRIOR YEAR MINIMUM TAX LIABILITY
In connection with the Book Minimum Tax, the Act would amend section 53(e) to allow an applicable corporation to offset its regular tax liability for the current taxable year by the amount of its Book Minimum Tax in prior years to the extent said Book Minimum Tax has not been credited against the applicable corporation’s regular tax liability in prior years. The amount of such credit for a taxable year is limited to the excess of the taxpayer’s regular tax liability over its tentative minimum tax, which equals 15% of its adjusted financial statement income minus any corporate AMT foreign tax credit.
TREATMENT OF STATE AND LOCAL TAX
The proposed legislation does not make any special adjustments for US state and local income taxes. When computing adjusted financial statement income, special adjustments are only made to disregard US federal income and foreign income taxes in the manner described above. Accordingly, US state and local taxes presumably are included as book deductions and reflected as such when computing adjusted financial statement income.
The proposed legislation provides relief for certain tax preference items when determining the amount of BMT owed, including accelerated depreciation deductions for tangible personal property, general business credits and pension deductions. In contrast, other frequent sources of disparity between book and tax amounts are not excepted, such as goodwill amortization, stock compensation expenses, certain accrued liabilities and the section 250 deduction.
If enacted, the Book Minimum Tax may, by increasing the tax rate on US companies, reduce the instances in which other countries’ OECD Pillar 2 rules (such as the UTPR) could apply to domestic profits of US companies. Because of differences between the Book Minimum Tax base and the Pillar 2 tax base, however, the Book Minimum Tax would not prevent the application of Pillar 2 rules to US companies’ domestic profits. Additionally, because the Book Minimum Tax does not impose a minimum tax on a country-by-country basis, it also would not prevent the application of other countries’ Pillar 2 rules to CFCs and foreign branches of US companies.