Sweeping tax reform legislation was signed into law on December 22, 2017. Commonly referred to as the Tax Cuts and Jobs Act (“the Act”) (P.L. 115-97), contains a broad range of provisions affecting corporations. While many of the provisions do not go into effect until 2018, corporations should immediately begin assessing how they will be impacted by tax reform. Though there are many moving parts in the Act, with the potential to affect corporations to varying degrees, this article highlights some of the most significant modifications impacting C corporations.
Reduction in Corporate Tax Rate
Under prior law, corporations paid tax at graduated rates with incomes over $335,000 taxed at 34 to 35 percent. The Act removes the graduated tax rate in favor of a flat 21 percent effective January 1, 2018.
Planning tip: The decrease in the corporate income tax rate will result in permanent cash tax savings to the extent taxable income may be deferred to years after 2017. Consider implementing tax accounting method changes for the last available tax year to which the pre-Act corporate tax rates apply. Automatic method changes may be filed until the due date of the 2017 tax return (including extensions).
Fiscal Year Filers
Fiscal year corporations with a tax year spanning both 2017 and 2018 calendar years will pay tax using a blended tax rate calculated pro rata, based on days in the tax year before and after the effective date of the tax rate change of January 1, 2018.
Repeal of Alternative Minimum Tax
The corporate alternative minimum tax (AMT) is fully repealed by the Act for tax years beginning after December 31, 2017. Any AMT credit carryforwards will offset the taxpayer’s regular tax liability and will be refundable, subject to certain limitations.
Changes in Net Operating Loss Deduction
The new provisions limit the net operating loss (NOL) deduction and carryback periods for corporations. The NOL deduction allowed for any given year is limited to 80 percent of taxable income. Additionally, the carryback of NOLs is now generally prohibited, whereas the carryforward period is indefinite. The new rules apply to losses generated in tax years ending after December 31, 2017.
Planning tips: The 80 percent limitation on post-2017 NOLs and the elimination of post-2017 NOL carrybacks provides an incentive to accelerate deductions to 2017 and defer income to 2018. Losses generated in years beginning prior to 2018 may fully offset 100 percent of future taxable income.
Temporary Full Expensing for Certain Business Assets
Corporations are temporarily allowed to expense 100 percent of the cost of certain depreciable assets acquired and placed in service after September 27, 2017 and before January 1, 2023. The 100 percent bonus depreciation rule applies through 2022, and is decreased by 20 percent, per year, until completely phased out in tax years beginning on or after January 1, 2027.
The Act modifies the definition of property eligible for bonus depreciation (“qualified property”). Pre-owned property is now eligible for bonus depreciation under the Act as long as the taxpayer has not previously used the property, and did not acquire it from a related party. In addition, the Act eliminates the qualified leasehold improvement, qualified restaurant and qualified retail improvement property asset types. Instead, the Act introduces a broadly-encompassing asset type called “qualified improvement property” which generally includes all improvements made to the interior of a nonresidential building after the year in which the building was originally placed in service.
Observation: Most assets with recovery periods of 20 years or less are eligible for the additional depreciation allowance. It appears that Congress intended to assign a 15-year depreciable recovery period to qualified improvement property, making it qualified property for bonus depreciation. However, the final legislation did not modify the definition of 15-year property to include qualified improvement property. As such, qualified improvement property acquired and placed in service after December 31, 2017, is not eligible for bonus depreciation and must be depreciated over a 39-year recovery period.
Planning tips: The immediate expensing provisions under the new law will have a significant impact on M&A transactions. Buyers will be highly motivated to pursue asset sales in order to take advantage of the immediate expensing provisions. This could give sellers more leverage in negotiating a lower sales price. With the decrease in tax rates, sellers may be more inclined to negotiate an acceptable price for an asset sale.
Interest Deduction Limitation
The new law generally limits the deduction for net business interest expense to the sum of business interest income, floor plan financing interest, and 30 percent of the adjusted taxable income of a taxpayer for the year. Adjusted taxable income is a business’s taxable income computed without regard to any item of income, gain, deduction or loss not properly allocable to the trade or business, business interest expense or business interest income, net operating loss deduction, the qualified business income deduction under new IRC §199A, or depreciation, amortization or depletion (in tax years beginning before January 1, 2022). Any disallowed interest deductions may be carried forward indefinitely.
Corporations with average annual gross receipts of $25 million or less, with the exception of tax shelters, are not subject to the interest deduction limitation. These provisions are effective for taxable years beginning after December 31, 2017.
Special Rules for Taxable Year of Inclusion
The Act introduces a significant change with regard to the timing of income recognition for certain deferred revenues. Accrual method taxpayers must recognize income no later than the year in which the amount is recognized as revenue in the taxpayer’s applicable financial statements. This means that, for tax purposes, revenue may no longer be deferred to a period later than when the corresponding revenue is recognized for financial reporting purposes. Further, income from advance payments is subject to a maximum one-year deferral.
Small Business Reform
The Act establishes a threshold of $25 million average annual gross receipts which is referenced for purposes of applying several small business simplifying provisions effective for taxable years beginning after December 31, 2017. The $25 million gross receipts test is applied when determining if a corporation, including related corporations and other entities, is a “small business” eligible for the exceptions to the: 1. requirement to use the accrual method of accounting, 2. requirement to account for inventories, 3. requirement to capitalize additional costs to inventory under the Uniform Capitalization rules, 4. interest deduction limitation and 5. requirement to use the percentage of completion method to account for certain long term contracts.
Research & Development Credits
Planning Tip: The final version of the Act leaves the Research and Development (R&D) Credit largely unchanged. However, because of changes in other areas of tax law, notably the corporate tax rate reduction from 35 to 21 percent, the R&D credit provides an enhanced tax opportunity for many corporations. The increased benefit is a result of the credits interaction with the R&D expense deduction. For a Company with a $100,000 R&D Tax Credit, the taxpayer will receive an additional $14,000 in cash tax savings as a result of the change. Additionally, for corporations with interest expense or NOL deduction limitations, the R&D credit is available to offset the residual tax liability due after these limitations. Previously, R&D was not creditable for AMT purposes so corporations in AMT could not benefit from an R&D credit. With the repeal of AMT, corporations that previously did not pursue the R&D credit may find that it provides fresh, beneficial tax savings.
Financial Reporting Considerations
In general, the effect of a change in tax laws or rates are to be recognized in a corporation’s financial statements as of the date of enactment. The tax effects of the Act must be reflected in the period including the enactment date of December 22, 2017. Note that this will include quarterly and annual reports for the period ended December 31, 2017.
The recent change in tax laws will have an effect on various financial statement components, including deferred taxes, valuation allowance and disclosures. The newly enacted 21 percent corporate income tax rate should be used to revalue assets and liabilities as of the date of enactment. Changes to the net operating loss regime will require a corporation to reassess the appropriateness of their valuation allowances.
A corporation’s income tax disclosures should include the implications of tax reform for the period of enactment. The SEC has issued transition guidance to allow entities to take a reasonable period of time to evaluate, measure and recognize the effects of the Act. During the measurement period, the SEC Staff expect that entities will act in good faith to account for income taxes under ASC 740. Under this transition guidance, corporations should account for the effects of tax reform where reasonably possible. To the extent complete tax accounting is not possible, taxpayers should calculate a reasonable estimate and provide complete accounting at a later date within the measurement period. Taxpayers are required to provide detailed disclosures describing why a reasonable estimate is not provided, if applicable.
Observation: Taxpayers with fiscal years ending before the date of enactment, but which issue financial statements after the date of enactment, do not have to reflect the impact of tax rate or tax law changes in their financial statements. However, they are subject to certain disclosure requirements for non-recognized subsequent events.
Corporations with International Operations
The international tax provisions under the Act substantially alter the taxation of foreign earnings. Most notably, the U.S. will operate under a quasi-territorial tax system as opposed to the prior worldwide tax regime. This is accomplished through the provision of a 100 percent dividend received deduction (DRD) on certain qualified dividends from foreign subsidiaries.
To effectuate the transition to a participation exemption regime, corporations are subject to a one-time mandatory repatriation tax on non-previously taxed post-1986 accumulated foreign earnings. A tax rate of 15.5 percent is imposed on amount of accumulated foreign earnings allocable to cash and cash equivalent assets while a tax rate of 8 percent is imposed on accumulated foreign earnings allocable to operating assets (e.g. real estate and other physical assets).
Observation: Foreign tax credits and NOL carryforwards may be utilized to offset the one-time transition tax. Taxpayers may elect to pay any tax due under this provision over an 8-year installment period.
The new tax law introduces provisions intended to battle base erosion by incentivizing U.S. companies for retaining their intellectual property in the U.S. and/or penalizing them for housing their intellectual property outside the U.S. Both the incentive and penalty aspects of the rules treat income in excess of a reasonable return (currently 10 percent) on depreciable assets as intangible income. To the extent that this excess “intangible” income is U.S. income from foreign sources, then it is Foreign Derived Intangible Income (FDII) and is subject to a preferential 13.125 percent tax rate. To the extent that this excess intangible income is earned by a controlled foreign corporation, then it is Global Intangible Low-Taxed Income (GILTI) and is subject to an additional tax.
To discourage U.S. companies from transferring assets to a foreign affiliate, thereby generating (1) a U.S. tax deduction for payments made to the foreign affiliate for the right to use of those assets, and (2) foreign-source income that is otherwise not taxable in the U.S. under the new participation exemption regime, The Act introduced a provision requiring corporations to pay the higher of its regular tax liability (21 percent) or an alternative base-erosion and anti-abuse tax (BEAT). The BEAT is a complex calculation with unclear terminology and limited guidance, but generally measures ineligible outbound payments against total U.S. deductions. A corporation is subject to the BEAT if it has average annual gross receipts exceeding $500 million and has ineligible payments exceeding 3 percent of U.S. deductions.
The new tax law eliminates foreign tax credits (FTCs) on dividends which are eligible for the 100 percent DRD. Further, the ability to utilize FTCs on certain sources of foreign income is restricted. Note that FTCs can be utilized to offset the one-time transaction tax but only at reduced rates matching the reduced transition tax rates. In general, the complexity of determining whether it is better to deduct foreign taxes or take a FTC and the amount of any FTC is greatly increased under the new tax law.
Changes to Definition of U.S. Shareholder and Stock Attribution Rules
The Act modifies the definition of a U.S. shareholder set forth in IRC §951(b) of the Code to include taxpayers owning 10 percent or more of the stock, by vote or by value, of a foreign corporation. Under pre-tax reform law, a U.S. person was categorized as a U.S. shareholder, only if they owned 10 percent or more of the voting stock of the foreign corporation. As a result, U.S. corporations which own significant amounts of nonvoting stock in foreign corporations may no longer avoid the U.S. shareholder and CFC status. Taxpayers with certain foreign interests will be subject to the Subpart F rules which previously were not.
State Tax Implications
Many of the changes introduced in the Act will have state and local tax implications. Since states enact their own tax rates, the federal tax rate reduction to 21 percent will not have a direct impact on tax rates imposed at the state level. However, for corporate income taxes, many states calculate their state taxable income using federal taxable income as a starting point and each jurisdiction conforms to federal tax law differently.
The decreased federal corporate income tax rate means that the state rate will now have a larger impact on tax planning and will increase the impact of state taxes on a corporation’s effective tax rate.
Finally, the reductions in the DRD, limitation on interest deductibility, limitation on NOL utilization, enhanced bonus depreciation and repeal of AMT will all affect a taxpayer’s federal tax base on many state and local returns. Non-conformity, with regard to these federal law changes, will most likely present disproportionately high levels of taxable income in many states - thereby increasing the total state income tax owed by businesses.
There are far more elements to the tax reform impacting corporations than are covered here. Management should consider familiarizing themselves with the finer details of the changes. Consulting your trusted tax advisor is strongly recommended to ensure you are prepared for the oncoming effects – both favorable and complex – to your business.
Haley Roberts, Manager | DHG Tax
843.727.3713 | firstname.lastname@example.org
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