Proposed Small Business Taxpayer Regulations Provide More Certainty of IRS’s Position on Accounting Methods Simplification

Summary of newly-released proposed regulations related to changes made under the TCJA.

On July 29, 2020, the IRS and Treasury released an advance copy of proposed regulations (REG-132766-18) to provide guidance for small business taxpayers to implement several statutory exemptions enacted by the 2017 tax reform bill known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, for the purpose of simplifying the method of accounting rules. Small business taxpayers are defined as having average annual gross receipts for the three taxable year period ending before the current taxable year not exceeding $25 million, adjusted for inflation (gross receipts test). For taxable years beginning in 2019 and 2020, the gross receipts amount has been adjusted to $26 million. Importantly, for gross receipts testing purposes, the aggregation rules of Section 448(c)(2) may apply to combine gross receipts of another entity.

The proposed regulations affect the use of the overall cash method of accounting, inventory methods, uniform capitalization rules under Section 263A (UNICAP), and long-term contracts. The statutory exemptions do not apply to businesses that are considered tax shelters, as discussed below. While these regulations provide additional clarity as to the positions the IRS is taking, we anticipate that taxpayers will continue to encounter significant complexities associated with implementing these rules.

The regulations are generally applicable to taxable years beginning on or after the date the final regulations are published in the Federal Register – e.g., for 2020 with respect to calendar year taxpayers. However, taxpayers have the option of relying on the proposed regulations for taxable years beginning after December 31, 2017, as long as all the applicable rules for each Code provision that a taxpayer chooses to apply are followed. There is guidance applicable to tax shelters and manufacturers that wish to treat their inventory as non-incidental materials and supplies that may require immediate action, as discussed below.

This alert discusses the highlights of the proposed regulations.
 

Definition of Tax Shelter

A tax shelter is always prohibited from using the simplifying methods described above, regardless of the amount of its gross receipts. A tax shelter is defined to include a syndicate under Section 1256(e)(3)(B), which is a partnership or other entity (other than a C corporation), of which more than 35% of that entity’s losses during the taxable year are allocable to limited partners or limited entrepreneurs. Temporary Reg. Section 1.448-1T(b)(3) narrows this definition by providing that a taxpayer is a syndicate only if more than 35% of its losses are allocated to limited partners or limited entrepreneurs. This means a partnership or other entity may be considered a syndicate only for a taxable year in which it has losses. The IRS noted in the preamble to the proposed regulations that they specifically did not permit relief from meeting the tax shelter definition to taxpayers that report negative taxable income in a taxable year solely because of a negative (favorable) Section 481(a) adjustment from an accounting method change.

The proposed regulations permit a taxpayer to elect to use the allocated taxable income or loss of the immediately preceding taxable year, instead of the current taxable year, to determine whether the taxpayer is a syndicate for purposes of Section 448 for the current taxable year. The preamble to the proposed regulations notes that a taxpayer making this election will have certainty at the beginning of its current taxable year as to whether it is a tax shelter or not. The election is made by attaching a statement to a timely filed original federal income tax return for the first taxable year for which the election is made. Once made, the election applies to all subsequent taxable years, and for all purposes for which status as a tax shelter is defined under Section 448(a)(3), including the Section 163(j) limitation on business interest deduction, unless the taxpayer obtains the IRS’s consent to revoke the election by filing a private letter ruling request. The proposed regulations state that no late elections will be permitted, and an election cannot be made by filing an amended return. Further, the election may never be revoked earlier than the fifth taxable year following the first taxable year for which the election was made unless extraordinary circumstances are demonstrated to the satisfaction of the IRS. Once an election has been revoked, a new election cannot be made until the fifth taxable year following the taxable year for which the election was revoked unless extraordinary circumstances are demonstrated to the satisfaction of the IRS.

The impact of this guidance is that making this election would allow an entity to obtain certainty at the beginning of the year as to whether it is required to use the overall accrual method, similar to a C corporation or a partnership with a C corporation partner that must apply the gross receipts test at the beginning of the year by looking at prior years’ gross receipts. But, by not modifying the definition of a tax shelter to exclude the syndicate definition, the proposed regulations continue to subject taxpayers meeting the syndicate definition to the Section 448 requirement to use the overall accrual method and exclude such taxpayers from the other statutory exclusions discussed in the proposed regulations that apply to small business taxpayers, including Section 163(j).

Overall Accounting Method

In general, Section 448 prohibits a C corporation, partnership with a C corporation partner, or tax shelter from using the overall cash receipts and disbursements method of accounting. C corporations and partnerships with a C corporation partner that meet the gross receipts test for the current year may use the overall cash method. Under the changes to Section 448 made by the TCJA, a C corporation or partnership with a C corporation partner is no longer prohibited from using the cash method of accounting for all future years after it first exceeds the gross receipts test; that is, if a taxpayer’s gross receipts fall under the gross receipts test threshold in subsequent years, it may be eligible to use the cash method of accounting again by filing an accounting method change. However, the proposed regulations maintain the eligibility restriction under Section 5.01(1)(e) of Rev. Proc. 2015-13 that prohibits a taxpayer from qualifying for an automatic accounting method change if it has made or requested an overall method change during any of the five taxable years ending with the year of change. Therefore, a taxpayer that has changed to the overall accrual method within this five-year period would have to file a non-automatic method change request to change back to the overall cash method. Given the IRS’s general five-year restriction on changing the same method of accounting, it is not surprising that IRS has not waived the restriction, which would permit taxpayers to switch back and forth between the overall cash and accrual methods in a shorter period of time. The preamble to the proposed regulations indicates that the IRS is concerned that multiple changes in a taxpayer’s overall method of accounting within a short period of time may cause income and expenses to not be treated consistently and that income may not be clearly reflected. Consequently, taxpayers that exceed the gross receipts test will generally be required to use the overall accrual method for five years before being able to change back to the overall cash method automatically, even if they fall within the gross receipts test threshold prior to the five-year period, or weigh the cost (including IRS filing fees and Form 3115 preparation fees) associated with filing a non-automatic change within the five-year period against the benefit of changing to overall cash. Conversely, a taxpayer that changes to the cash method will generally be able to automatically change to the overall accrual method for the first year that it exceeds the gross receipts test, without having to wait for five years.

Treatment of Inventory

Under Section 471, inventories are required in a taxable year in which the production, purchase, or sale of merchandise is an income-producing factor; if inventories are required, an accrual method must be used for purchases and sales. The TCJA permitted taxpayers that meet the gross receipts test and that are not tax shelters under Section 448 to be exempt from Section 471 and to use certain simplified inventory methods, specifically to either (1) treat its inventory as non-incidental materials and supplies (Section 471(c) materials and supplies) or to (2) conform to its inventory method used in its applicable financial statement (AFS), or the taxpayer’s books and records prepared in accordance with its accounting procedures, if it does not have an AFS.

Taxpayers that choose to treat inventory as Section 471(c) materials and supplies are required to treat such costs as deductible in the year in which they are actually consumed and used in the taxpayer’s business. The proposed regulations state that Section 471(c) materials and supplies are considered to be used or consumed in the taxable year in which the taxpayer provides the item to a customer or the taxable year in which the taxpayer pays for or incurs such cost, whichever is later. The preamble to the proposed regulations indicates that the IRS believes the TCJA Conference Report requires the recovery of non-incidental materials and supplies to be consistent with the law in existence when the TCJA was passed. The law in effect at that time was administrative guidance under Rev. Proc. 2001-10 and Rev. Proc. 2002-28 that provided the same rule as in the proposed regulations. Thus, the IRS does not adopt a rule, suggested by a commenter, that for manufacturers, raw materials used to produce finished goods would be deemed used or consumed when the raw materials were used during production, which would permit the deduction to be taken earlier than in the proposed guidance. As such, taxpayers that took a position to deduct raw materials in the year the amounts were used in production and filed a method change with their 2018 or 2019 return to do so may need to consider whether to file another method change to comply with the proposed regulations, or wait until the regulations are finalized to assess whether the government will reconsider the position. While taxpayers are not required to conform to this rule until and unless it is finalized, it is possible that IRS examiners may look to the rule as the position they should take in an examination.

A taxpayer may make another automatic accounting method change under Section 22.19 of Rev. Proc. 2019-43 to conform to the proposed regulations’ determination of when Section 471(c) materials and supplies are used or consumed, or to change to use the taxpayer’s inventory method used in its applicable financial statements (or its books and records prepared in accordance with its accounting procedures, if it does not have an applicable financial statement). The eligibility restriction prohibiting a change in the same item within five taxable years is waived for the first, second, and third taxable year beginning after December 31, 2017. Thus, under the current procedural rules, taxpayers that become subject to the Section 471 requirements when their gross receipts exceed the threshold will generally need to remain on their Section 471 method for at least five years, even if their gross receipts drop below the threshold sometime within the five year period.

Questions have arisen as to whether a taxpayer treating its inventory as non-incidental materials and supplies may use the de minimis safe harbor election under Reg. Section 1.263(a)-1(f). The de minimis safe harbor election permits a taxpayer to deduct amounts paid for the acquisition or production of a unit of tangible property; such amounts would not be capitalized or treated as a material or supply it if the taxpayer meets the requirements of the safe harbor. The proposed regulations clarify the IRS’s position that the de minimis safe harbor election does not apply to Section 471(c) materials and supplies. The IRS believes that Section 471(c) materials and supplies retain their characterization as inventory property, and inventory is not eligible for the de minimis safe harbor election. This position is consistent with the position the IRS took at the time the tangible property regulations were released in FAQs published on their website.

The proposed regulations further provide that a taxpayer may identify and value their Section 471(c) materials and supplies using either a specific identification method; a first-in, first-out method; or an average cost method, provided the method is used consistently. The last-in, first-out method or lower-of-cost-or market methods may not be used, because, according to the IRS, they require sophisticated computations and the purpose of the exception from inventory is to provide simplification. A taxpayer using the Section 471(c) materials and supplies method is required to include only direct costs paid to produce or acquire the inventory as Section 471(c) materials and supplies, but not overhead costs. Accordingly, there could still be an opportunity for acceleration of certain deductions under this approach. 

To the extent that a small business taxpayer chooses not to treat inventory as Section 471(c) materials and supplies, the proposed regulations also provide guidance for a taxpayer that wishes to treat its inventory in accordance with its applicable financial statement (AFS Section 471(c) method). The definition of an AFS references the definition used in Section 451(b)(3) and the proposed regulations under Sections 1.451-3(c)(1) and 1.451-3(h). A taxpayer’s inventory costs are the costs that a taxpayer capitalizes for property produced or property acquired for resale in its AFS. A taxpayer is not permitted to recover a cost that it otherwise would be neither permitted to recover nor deduct for federal income tax purposes solely by reason of it being an inventory cost in the taxpayer’s AFS inventory method. Further, a taxpayer may not capitalize a cost to inventory any earlier than the taxable year in which the amount is paid or incurred under its overall method of accounting for federal income tax purposes, nor a cost that is not permitted to be capitalized by another Code provision. This may require a reconciliation of any differences between a taxpayer’s AFS and federal income tax return treatment for costs included in the taxpayer’s AFS inventory method under the AFS Section 471(c) method. The IRS states that it believes the exemption for the inventory rules of Section 471(a) does not exempt taxpayers from applying other Code provisions that determine the deductibility or recoverability of costs, or the timing of when costs are considered paid or incurred. These rules also apply to a taxpayer without an AFS that elects to treat inventory as reflected in its books and records prepared in accordance with its accounting procedures. Additionally, this non-AFS Section 471(c) method requires that a method that determines ending inventory and cost of goods sold that properly reflects the taxpayer’s business activities for non-federal income tax purposes be used; for example, a taxpayer that performs a physical count of inventory that it uses in reports to its creditor must use that count for purposes of the non-AFS Section 471 method, even though the taxpayer treats all costs paid during the taxable year as presently deductible.  

Long-Term Contracts

Section 460 requires the use of the percentage of completion method (PCM) for long-term contracts. Under the PCM, a taxpayer must include in income a portion of its total contract revenue based on the ratio of costs incurred during the taxable year over total costs expected to be incurred for the contract, regardless of when cash is actually received. However, small business taxpayer construction contracts that are expected to be completed within a two-year period are exempt from PCM, as well as home construction contracts in general. The preamble to proposed regulations clarify that a taxpayer may adopt any permissible method of accounting for each type of contract. In addition, the proposed regulations confirm that taxpayers are required to file a method change in situations in which a taxpayer has been using PCM for exempt contracts and seeks to change to a different exempt contract method, such as the completed contract method.

The proposed regulations also provide additional rules related to the look-back method, which requires taxpayers subject to PCM to determine upon the completion of long-term contracts whether they must pay interest or are entitled to receive interest to the extent differences exist between the estimated contract costs and actual total contract costs. In particular, the proposed regulations provide that taxpayers subject to the base erosion anti-abuse tax (BEAT) under Section 59A must apply the look-back method to re-determine the taxpayer’s modified taxable income and the taxpayer’s base erosion minimum tax amount for each year prior to the filing year that is affected by contracts completed or adjusted in the filing year as if the actual total contract price and costs had been used in applying the percentage of completion method. The preamble indicates this update is necessary because the income from long-term contracts determined using the PCM may be overestimated or underestimated, which may change the taxpayer’s modified taxable income or base erosion minimum tax amount, or whether or not a taxpayer is an applicable taxpayer in a particular taxable year.

The relatively short time frame between the issuance of these proposed regulations and the extended due dates for calendar year 2019 federal tax returns means that there is not much reaction time to evaluate the taxpayer’s methods affected by these regulations and determine if action is needed before the 2019 tax return is filed. Taxpayers should familiarize themselves with the guidance to determine whether any immediate action items may be necessary for their 2019 tax year and take appropriate actions.

If you have any questions, please contact a member of the Accounting Methods group. The Accounting Methods group within BDO USA’s National Tax Office has extensive experience assisting taxpayers of all industries and sizes with their accounting method issues and filing accounting method change requests with the IRS.
 


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International Aspects of the 2020 Section 163(j) Proposed Regulations

Summary

On July 28, 2020, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) released final regulations under Section 163(j). On the same date, Treasury released proposed regulations under Section 163(j), which includes among many other items, guidance for how the business interest deduction limitation rules under Section 163(j) apply to U.S. shareholders, as defined in Section 951(b), of controlled foreign corporations (CFCs), as defined in Section 957(a), and to foreign persons with effectively connected income (ECI) in the United States.
 

Details

On December 28, 2018, Treasury published in the Federal Register proposed regulations under Section 163(j) (REG-106089-18). For a summary discussion of the international aspects to the 2018 proposed regulations, see our November 2018 tax alert. The final regulations largely reserve on the application of the Section 163(j) limitation to foreign corporations and U.S. shareholders and foreign persons with ECI.[1] Instead, the new proposed regulations include rules that substantially modify the 2018 proposed regulations with respect to foreign corporations and U.S. shareholders and foreign persons with ECI. This alert summarizes some of the key international items included in the proposed regulations.
 

1. Foreign Corporations and U.S. Shareholders  

Section 163(j) and the Section 163(j) regulations apply to determine the deductibility of a relevant foreign corporation’s business interest expense for purposes of computing its taxable income for U.S. income tax purposes (if any) in the same manner as those provisions apply to determine the deductibility of a domestic C corporation’s business interest expense for purposes of computing its taxable income.[2] Proposed §1.163(j)-7 however, generally allows for an election to be made to apply Section 163(j) on a group basis with respect to applicable CFCs that are “specified group members” of a “specified group” where a single Section 163(j) limitation is computed for a CFC group.[3] For this purpose, the current-year business interest expense (BIE), disallowed BIE carryforwards, business interest income (BII), floor plan financing interest expense, and adjusted taxable income (ATI) of a CFC group are equal to the sums of the current-year amounts of such items for each CFC group member for its specified taxable year with respect to the specified period. A CFC group member’s current-year BIE, BII, floor plan financing interest expense, and ATI for a specified taxable year are generally determined on a separate-company basis before being included in the CFC group calculation. The extent to which a CFC group’s Section 163(j) limitation is allocated to a particular CFC group member’s current-year BIE and disallowed BIE carryforwards is determined using the rules that apply to consolidated groups under §1.163(j)-5(a)(2) and (b)(3)(ii) (consolidated BIE rules), subject to certain modifications.[4]
 
The disallowed BIE carryforwards of a CFC group member when it joins a CFC group (pre-group disallowed BIE carryforwards) are subject to the same CFC group Section 163(j) limitation and are deducted pro rata with other CFC group disallowed BIE carryforwards. However, pre-group disallowed BIE carryforwards are subject to additional limitations, similar to the limitations on deducting the disallowed BIE carryforwards of a consolidated group arising in a separate return limitation year (SRLY), as defined in §1.1502-1(f) or treated as arising in a SRLY under the principles of §1.1502-21(c) and (g).
 
In addition, the proposed regulations include rules for determining specified groups and specified group members along with rules for making or revoking a CFC group election. Also, the proposed regulations also include special rules for applying Section 163(j)(10) and the election under §1.163(j)-2(b)(3)(i) to CFC groups.
 
In response to comments, proposed §1.163(j)-7 does not provide for CFC financial services subgroups. Instead, applicable CFCs that otherwise qualify as CFC group members are treated as part of the same CFC group.
 
Proposed §1.163(j)-7 provides that an applicable CFC with ECI is not precluded from being a CFC group member. However, under proposed §1.163(j)-7(f), only the ATI, BII, BIE, and floor plan financing of the applicable CFC that are not attributable to ECI are included in the CFC group’s Section 163(j) calculations. The ECI items of the applicable CFC are not included in the CFC group calculations. Instead, the ECI of the applicable CFC is treated as income of a separate CFC, an “ECI deemed corporation,” that has the same taxable year and shareholders as the applicable CFC, but that is not a CFC group member. The ECI deemed corporation must do a separate Section 163(j) calculation for its ECI in accordance with proposed §1.163(j)-8.
 
Proposed §1.163(j)-7 also provides an anti-abuse rule that increases ATI in certain circumstances. See proposed §1.163(j)-7(g)(4) for additional details. 
 
Proposed §1.163(j)-7 provides a safe harbor election that exempts certain applicable CFCs from application of Section 163(j). The safe-harbor election is available for stand-alone applicable CFCs (which is an applicable CFC that is not a specified group member of a specified group) and CFC group members. The election is not available for an applicable CFC that is a specified group member but not a CFC group member because a CFC group election is not in effect. If the election is made, then no portion of any CFC excess taxable income is included in a U.S. shareholder’s ATI.[5]
 
In the case of a stand-alone applicable CFC, the safe-harbor election may be made for a taxable year of the stand-alone applicable CFC if its BIE does not exceed 30% of the lesser of (i) its tentative taxable income attributable to non-excepted trades or businesses (referred to as “qualified tentative taxable income”), and (ii) its “eligible amount” for the taxable year. In the case of a CFC group, the safe-harbor election may be made for the specified taxable years of each CFC group member with respect to a specified period if the CFC group’s BIE does not exceed 30% of the lesser of (i) the sum of the qualified tentative taxable income of each CFC group member, and (ii) the sum of the eligible amounts of each CFC group member. For taxable years of a stand-alone applicable CFC or specified periods of a CFC group beginning in 2019 or 2020, the 30% limitation is replaced with a 50% limitation, consistent with the change in the Section 163(j) limitation to take into account 50%, rather than 30%, of ATI for such taxable years or specified periods.
 
The “eligible amount” is a CFC-level determination. In general, the eligible amount is the sum of the applicable CFC’s Subpart F income plus the approximate amount of GILTI inclusions its U.S. shareholders would have were the applicable CFC wholly owned by domestic corporations that had no tested losses and that were not subject to the Section 250(a)(2) limitation on the Section 250(a)(1) deduction. Amounts used in the determination of the eligible amount are computed without regard to the application of Section 163(j) and the Section 163(j) regulations. While the eligible amount of an applicable CFC cannot be negative, qualified tentative taxable income can be negative. Thus, limiting the safe-harbor to 30% of qualified tentative taxable income ensures that losses of a stand-alone applicable CFC or a CFC group are taken into account in determining whether the stand-alone applicable CFC or the CFC group qualifies for the safe-harbor.
 
The safe-harbor election does not apply to EBIE, as described in §1.163(j)-6(f)(2), and EBIE is not taken into account for purposes of determining whether the safe-harbor election is available for a stand-alone applicable CFC or a CFC group, until such business interest expense is treated as paid or accrued by an applicable CFC in a succeeding year (that is, until the applicable CFC is allocated excess taxable income or excess business interest income from such partnership in accordance with §1.163(j)- 6(g)(2)(i)).
 
The proposed regulations provide that a safe-harbor election cannot be made for a CFC group that has pre-group disallowed BIE carryforward.
 
As a general matter, a U.S. shareholder does not include in its ATI any portion of its specified deemed inclusions. Specified deemed inclusions include the U.S. shareholder’s deemed income inclusions attributable to an applicable CFC and a non-excepted trade or business of the U.S. shareholder.[6] Proposed §1.163(j)-7 however, allows a U.S. shareholder of a stand-alone applicable CFC or a CFC group member of a CFC group to include a portion of its deemed income inclusions attributable to the applicable CFC in the U.S. shareholder’s ATI. This rule does not apply with respect to an applicable CFC that is a specified group member but not a CFC group member because a CFC group election is not in effect. If a safe-harbor election is in effect with respect to the taxable year of a stand-alone applicable CFC or the specified period of a CFC group, CFC excess taxable income is not calculated for the stand-alone applicable CFC or the CFC group members.
 

2. Foreign Persons with Effectively Connected Income  

Proposed §1.163(j)-8(b)(1)-(5) provides that, for purposes of applying Section 163(j) and the Section 163(j) regulations to a specified foreign person, certain definitions (ATI, BIE, BII, and floor plan financing interest expense) are modified to take into account only ECI items. Additionally, proposed §1.163(j)-8(b)(6) provides that, for purposes of applying §1.163(j)-10(c) to a specified foreign person, only ECI items and assets that are U.S. assets are taken into account in determining the amount of interest income and interest expense allocable to a trade or business.
 
Proposed §1.163(j)-8(c) includes rules to determine the portion of a specified foreign partner’s allocable share of ETI, EBIE, and EBII (as determined under §1.163(j)-6) that is treated as ECI and the portion that is not treated as ECI. Proposed §1.163(j)-8(d) includes rules to determine the portion of deductible and disallowed BIE of a relevant foreign corporation (as defined in §1.163(j)-1(b)(33)) that is characterized as ECI or not ECI. Proposed §1.163(j)-8(e) provides rules regarding disallowed BIE. Proposed §1.163(j)-8(f) provides rules coordinating the application of Section 163(j) with §1.882-5 and similar rules and with the branch profits tax.
 

3. Applicability Dates  

Final §1.163(j)-7 applies to taxable years beginning on or after 60 days after the date of publication in the Federal Register.[7] However, taxpayers and their related parties, within the meaning of Sections 267(b) and 707(b)(1), may choose to apply the rules of final §1.163(j)-7  to taxable years beginning after December 31, 2017, so long as the taxpayers and their related parties consistently apply the rules of the Section 163(j) regulations, and, if applicable, §§1.263A-9, 1.263A-15, 1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0, 1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1, 1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through 1.1502-99 (to the extent they effectuate the rules of §§1.382-2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4, to those taxable years.
 
The proposed regulations are proposed to apply to taxable years beginning on or after 60 days after the date the Treasury Decision adopting these rules as final regulations is published in the Federal Register.
 
Taxpayers and their related parties, within the meaning of Sections 267(b) and 707(b)(1), who choose to apply the final regulations to taxable years beginning after December 31, 2017, and before 60 days after the date the final regulations are published in the Federal Register, may rely on proposed §§1.163(j)-7 and 1.163(j)-8 for those taxable years. Taxpayers who choose not to apply the final regulations for those taxable years may not rely on either proposed §1.163(j)-7 or 1.163(j)-8 for those taxable years. For any taxable year beginning on or after 60 days after the date the final regulations are published in the Federal Register and before 60 days after the date the Treasury Decision adopting the proposed regulations as final regulations is published in the Federal Register, taxpayers and their related parties, within the meaning of Sections 267(b) and 707(b)(1), may rely on proposed §§1.163(j)-7 and 1.163(j)-8 provided they consistently follow all of the rules of §§1.163(j)-7 and 1.163(j)-8 for such taxable year and for each subsequent taxable year beginning before 60 days after the final version of these proposed regulations is published in the Federal Register.[8]
 
For additional applicability dates and details including items not discussed in this summary, see the proposed regulations.
 


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[1]Final §1.163(j)-7(b) provides that, except as otherwise provided in this section, Section 163(j) and the Section 163(j) regulations apply to determine the deductibility of a relevant foreign corporation’s business interest expense for purposes of computing its taxable income for U.S. income tax purposes (if any) in the same manner as those provisions apply to determine the deductibility of a domestic C corporation’s business interest expense for purposes of computing its taxable income. See also §1.952-2. If a relevant foreign corporation is a direct or indirect partner in a partnership, see §1.163(j)-6 (concerning the application of Section 163(j) to partnerships). Additionally, final §1.163(j)-7(g)(1) provides that, for purposes of computing the tentative taxable income of a relevant foreign corporation for a taxable year, the relevant foreign corporation’s gross income and allowable deductions are determined under the principles of §1.952-2 or under the rules of Section 882 for determining income that is, or deductions that are allocable to, effectively connected income, as applicable. Final §1.163(j)-7(g)(2) provides rules for related party dividends.  Most of the other provisions of  final §1.163(j)-7 are reserved and final §1.163(j)-8 is reserved.
[2] While not the focus of this alert, it should be noted that final §1.163(j)-7(g)(2) states that for purposes of computing the ATI of a relevant foreign corporation for a taxable year, any dividend included in gross income that is received from a related person, within the meaning of Section 954(d)(3), with respect to the distributee is subtracted from tentative taxable income.
[3] See proposed §1.163(j)-7(c)(2).
[4] See proposed §1.163(j)-7(c)(3)(i).
[5] See proposed §1.163(j)-7(j)(2)(iv).
[6] See §1.163(j)-1(b)(2)(ii)(G).
[7] Final §1.163(j)-8 is reserved.
[8] See also proposed §§1.163(j)-7(m) and 1.163(j)-8(j).

Recent State Legislative and Administrative Reactions to the CARES Act

Summary

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was enacted, which among numerous other provisions, modified certain business tax provisions in the Internal Revenue Code (IRC). After the Tax Cuts and Jobs Act (TCJA) in December 2017 amended these same provisions in the IRC, states and taxpayers have only recently come to understand the conformity implications of the TCJA. The CARES Act modifications have presented a new round of conformity challenges for states, taxpayers, and practitioners.  See BDO’s previous alert that discusses the state and local tax (SALT) implications of the CARES Act.
 
Unlike the federal government, most states are required to have balanced budgets.  Due to COVID-19 and the resulting economic downturn, compounded by the fact that most states extended their income tax payment dates, many states are struggling to meet their balanced budget requirements.  This has resulted in some states changing their fiscal year end date, changing their IRC conformity dates, and decoupling from favorable business provisions of the CARES Act because not doing so would reduce tax revenues even further.  Some common CARES Act provisions that states have decoupled from include the increased business interest expense limitation under IRC Section 163(j), net operating loss (NOL) carrybacks and temporary suspension of NOL limitation under IRC Section 172, and deferring the application of the limitation on excess business losses under IRC Section 461(l).  So far, states that have responded to the CARES Act are mostly choosing to stick with the TCJA and not conform with the CARES Act.  States are also starting to address the Paycheck Protection Program (PPP), as well as the CARES Act’s technical correction applicable to qualified improvement property (QIP).
 
This alert focuses on legislative changes and administrative guidance related to IRC conformity dates and CARES Act decoupling provisions for businesses. See previous BDO SALT alerts that discuss similar updates in California, New York, North Carolina, and Michigan.

Details

Connecticut

On July 6, 2020, the Department of Revenue Services issued administrative guidance on two issues.  OCG-10: Regarding the Connecticut Tax Implications of the CARES Act indicates that federal stimulus checks are not subject to Connecticut’s individual income tax.  It also indicates that PPP loan forgiveness is not subject to Connecticut income tax, but the guidance does not address the issue of whether the taxpayer can deduct the expenses (for covered payroll, rent, and utilities) related to PPP loans that are forgiven.
 
OCG-10 also indicates that Connecticut follows the CARES Act’s suspension of the excess business loss limitation for noncorporate taxpayers under IRC Section 461(l) for tax years 2019 and 2020.  Because Connecticut applies its own NOL deduction and carryforward provisions, the CARES Act amendments to IRC Section 172 are not pertinent to Connecticut.  Also, after the TCJA was enacted, Connecticut fully decoupled from IRC Section 163(j) for corporation business tax, so the CARES Act amendments to Section 163(j) do not apply for Connecticut corporation business tax purposes, although they will for personal income tax.
 
OCG-11: Regarding Depreciation of Qualified Improvement Property for Connecticut Tax Purposes indicates that Connecticut follows the QIP technical correction but reminds taxpayers that Connecticut does not conform to the ability to claim bonus depreciation on QIP assets under IRC Section 168(k).  The guidance goes on to discuss how taxpayers should recognize the depreciation change, depending on whether the taxpayer filed an amended federal return or made an IRC Section 481(a) adjustment after filing Form 3115.
 

Colorado

Although Colorado is a rolling IRC conformity state, the Department of Revenue issued Emergency Rules 39-22-103(5.3) and 39-22-303.6–1 on June 2, 2020, which state that amendments to the IRC only apply prospectively.  In other words, the IRC for Colorado purposes does not, for any taxable year, incorporate federal statutory changes that are enacted after the last day of that taxable year. As a result, the CARES Act changes that impact 2018 or 2019 do not currently apply to Colorado.
 
On June 26, 2020, Governor Polis signed H.B. 1024, which states that NOLs generated by corporations, including financial institutions, may be carried forward only 20 years for tax years beginning on or after January 1, 2021.  NOLs generated in tax years beginning before January 1, 2021, can be carried forward “for the same number of years as allowed for a federal net operating loss.” However, if a financial institution generates an NOL for any taxable year beginning on or after January 1, 1984, and before January 1, 2021, said NOL can be carried forward to each of the 15 years following the taxable year of such loss. H.B. 1024 also clarifies that corporate NOLs are not allowed to be carried back.
 
Then, effective July 11, 2020, Colorado enacted H.B. 1420. In that bill, Colorado decoupled from the business-friendly provisions of the CARES Act for both corporate income tax and personal income tax.  Effectively, Colorado maintains conformity with the TCJA, but decouples from the CARES Act on the following provisions: IRC Sections 163(j), 172, and 461(l).
 

District of Columbia

Effective June 9, 2020, by temporary legislation under Act 23-328, the District of Columbia amended its income tax laws to limit deductions for NOL carryforwards to 80% of the apportioned NOL carryforward for corporation income tax and unincorporated business franchise tax purposes for tax years beginning after December 31, 2017.  Additionally, the temporary legislation conforms to the exclusion from gross income of PPP loan forgiveness under the CARES Act, but does not address deduction of related covered expenses.

 
Georgia

On June 30, 2020, Georgia enacted H.B. 846.  For both corporate and personal income tax, the new law updates Georgia’s IRC conformity date to March 27, 2020.  The updated IRC conformity date applies to tax years beginning on or after January 1, 2019.
 
However, Georgia specifically decouples from the CARES Act provisions related to NOLs found under IRC Section 172.  Therefore, Georgia decouples from the CARES Act amendment allowing a five-year NOL carryback for NOLs incurred in the 2018 through 2020 tax years, as well as the temporary suspension of the 80% NOL limitation. The legislation also decouples from the CARES Act amendments to IRC Section 461(l).
 

Iowa

On June 29, 2020, Iowa enacted H.F. 2641, an Omnibus Tax Bill that includes many tax-related items. The bill decouples entirely from IRC Section 163(j), effective for tax years beginning on or after January 1, 2020.  Any excess interest carryover from a prior tax year that is carried to 2020 or a future tax year and that is deducted for federal tax purposes is not eligible for an Iowa deduction.  Such excess interest must be added back to Iowa’s federal taxable income starting point.  Further, effective for tax years beginning on or after January 1, 2019, H.F. 2641 also decouples from federal GILTI treatment, provides a subtraction modification for GILTI income “to the extent included” in federal taxable income (see below), and instructs the Department of Revenue to rescind prior administrative rules that addressed the apportionment of GILTI.   The legislation also adopts the federal partnership centralized audit procedures and changes how individual and corporate taxpayers treat the increased expensing allowance under IRC Section 179.
 
Following the enactment of Iowa’s Omnibus Tax Bill, on July 17, 2020, the Iowa Department of Revenue issued Reform Guidance with respect to the GILTI subtraction modification.  The guidance clarifies that the subtraction is of the “net GILTI” amount (i.e., GILTI income less the amount deducted under IRC Section 250(a)(1)(B)).  Further, the Department indicated that while the IRC Section 250 GILTI deduction will not be allowed, the FDII deduction under IRC Section 250(a)(1)(A) is allowed.  In addition, the Department also indicated that the GILTI subtraction applies only for Iowa corporation income tax purposes and not for personal income tax.
 
Also, following the enactment of Iowa’s Omnibus Tax Bill, the Department issued additional guidance on its nonconformity to the CARES Act. The guidance applies H.F. 2641, and it focuses on how Iowa conforms or decouples from various federal provisions for the 2018, 2019, and 2020 tax years.
 

  • A taxpayer’s PPP loan that is forgiven and properly excluded from federal gross income under Section 1106(i) of the CARES Act in a tax year beginning on or after January 1, 2019, will also qualify for exclusion from income for Iowa tax purposes. Iowa will follow federal guidance on the deduction disallowance for covered expenses related to PPP loan forgiveness.
  • Iowa NOLs are calculated independently of federal NOLs, so the CARES Act changes to IRS Section 172 do not directly apply to the Iowa treatment of NOL deductions.
  • Regarding excess business losses under IRC Section 461(l), Iowa did not conform with the TCJA’s excess business loss limitation for tax year 2018, so the temporary suspension of the excess business loss limitation in the CARES Act should have no effect on the calculation of net income on 2018 Iowa income tax returns. Iowa also did not conform to IRC Section 461(l) for the 2019 tax year.  As such, if a taxpayer filed its 2019 return after the CARES Act was enacted, then the taxpayer may be required to file an amended return.
  • Regarding modifications on the limitation of business interest under IRC Section 163(j), Iowa likewise does not conform to the CARES Act changes.  For the 2019 tax year, Iowa follows the TCJA version of IRC Section 163(j). As such, if a taxpayer filed its 2019 return after the CARES Act was enacted, then the taxpayer may be required to file an amended return.
  • Regarding the QIP technical correction, according to the Department of Revenue, Iowa does not conform with this treatment for property placed in service during tax years 2018 and 2019, and instead treats QIP as 39-year property.  However, Iowa will conform to the QIP correction for property placed in service in 2020 and ensuing years.

  

Massachusetts

On July 13, 2020, the Massachusetts Department of Revenue issued TIR 20-9: Massachusetts Tax Implications of Selected Provisions of the Federal CARES Act.  The TIR addresses both corporate and individual income tax.
 
For corporate excise tax purposes, Massachusetts is a rolling conformity state, and it has not specifically decoupled from any provisions within the CARES Act. Therefore, the guidance indicates that Massachusetts follows the federal provisions related to PPP loan forgiveness, modifications to the limitation on business interest deduction found under IRC Section 163(j), technical corrections to QIP, and modifications to the limitation on charitable contributions during 2020.  Massachusetts, however, does not conform to IRC Section 172.  As a result, the CARES Act NOL amendments are not followed by Massachusetts.
 
For personal income tax purposes, Massachusetts generally follows the IRC in effect on January 1, 2005, except for certain specific IRC sections that are followed on a “rolling” basis.  As a result, Massachusetts does not conform to several of the federal provisions enacted or amended by either the TCJA or the CARES Act. For example, the guidance indicates that PPP loan forgiveness is includable in gross income of an individual; however, deductions are allowed for covered expenses related to the forgiven PPP loan. Similar to its corporate excise tax, Massachusetts does not conform to IRC Section 172 for personal income tax. Massachusetts does specifically adopt the current provisions of IRC Section 163(j), as well the technical correction to QIP, without adopting bonus depreciation under IRC Section 168(k).
 

Mississippi

On June 30, 2020, Mississippi enacted H.B. 1748, which conforms to the CARES Act exclusion from gross income of PPP loan forgiveness, effective January 1, 2020.As with most of the other states, the legislation does not address deductibility of covered expenses related to forgiven PPP loans.
 

New Mexico

On June 6, 2020, New Mexico enacted H.B. 6.  Effective immediately, the new law revises New Mexico’s corporate income tax definitions of NOLs to maintain conformity with the NOL-related definitions and provisions under the IRC as of January 1, 2018.  Thus, New Mexico effectively follows the federal treatment of NOLs found under the TCJA, and New Mexico decouples from the NOL-related provisions under the CARES Act.
 

New York City

On June 17, 2020, S.B. 08411 / A.B. 10519 was enacted, which decouples New York City (NYC) from various provisions of the CARES Act.  For tax years beginning before January 1, 2021, NYC decouples from the CARES Act changes to IRC Section 163(j) and IRC Section 172 when calculating NYC’s unincorporated business tax, general corporation tax, banking corporation tax, and business corporation tax.  Thus, NYC decoupled from the new five-year carryback for NOLs incurred in the 2018-2020 tax years, as well as the temporary suspension of the 80% limitation under IRC Section 172 enacted by the CARES Act.  NYC also decoupled from the increase in the IRC 163(j) business interest expense limitation from 30% to 50% for the 2019 and 2020 tax years.

 
Wisconsin

On April 15, 2020, Wisconsin enacted Assembly Bill 1038, which selectively conforms to the CARES Act and other federal relief measures.  Specifically, Wisconsin conforms to the QIP technical correction, as well as the federal gross income exclusion of PPP loan forgiveness, but does not address deductions of related covered expenses.
 

 


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IRS Proposes Excise Tax Relief for Exempt Organization Executive Compensation Under Code Section 4960

The IRS recently proposed regulations under Internal Revenue Code (IRC) Section 4960 that, among other things, would allow certain tax-exempt organizations and related for-profit entities to avoid paying 21% excise taxes on certain executive compensation. Even better, taxpayers may rely on the proposed regulations until final regulations are issued. The new rules are generally consistent with, and build further on Notice 2019-09 (issued on December 31, 2018), which provided helpful initial guidance on Section 4960. See our primer on 4960. With a few exceptions, the proposed regulations are consistent with the interim guidance provided in Notice 2019-09, so it seems likely that final regulations will not include any major changes to the proposed rules. Comments on the proposed rules are due by August 10, 2020. Read on for more information about this tax liability and potential relief.

Background

The Tax Cuts and Jobs Act of 2017 (Public Law 115-97) created IRC Section 4960. As a result, starting in 2018, most tax-exempt organizations and certain governmental units, as well as for-profit employers who “control” or who are “controlled by” an “applicable tax exempt organization” (ATEO), may owe a 21% excise tax on (1) annual “remuneration” over $1 million paid to “covered employees” or on (2) any “excess parachute payments” (even if those are under $1 million).

ATEOs of all sizes (and their related for-profit entities) might owe this tax if they paid any employee $125,000 or more during any year beginning on or after January 1, 2018. So even if the ATEO never paid any employee more than $1 million, the tax on excess parachute payments made to “highly compensated employees” could still be owed.

Section 4960 introduced several important new defined terms, including the following:

“Excess parachute payments” are amounts that exceed three times the covered employee’s five-year average wages and are contingent on an involuntary termination of employment.

“Remuneration” generally means 3401(a) wages paid during a calendar year ending with or within the employer’s tax year, excluding (1) Roth, tax-qualified retirement plans, 403(b) plan and governmental 457(b) plan contributions and distributions and (2) amounts paid to a licensed medical professional for the direct performance of medical services, but including amounts required to be included in income under 457(f)’s special timing rules (i.e., amounts are generally taken into account for the 4960 excise tax in the calendar year when the amount vests, regardless of when it is paid or included in income).  
 

  • The proposed rules confirm that this special timing rule for determining annual remuneration does not include the 457(f) exceptions for short-term deferrals, certain severance payments and earnings on vested nonqualified deferred compensation (so such amounts would be included when determining 4960 excise tax). For example, short-term deferrals under 457(f) and 409A may be included in an employee’s taxable income in a different year than the year that those amounts must be included in 4960 excise tax calculations. Likewise, subsequent earnings on vested 457(f) amounts would be included in taxable income in a different year than the year those amounts must be included in 4960 excise tax calculations (for 4960, subsequent earnings on vested amounts are treated as paid annually, even if the amounts are not actually paid until later).
  • Under the proposed rules, remuneration and parachute payments that vested before the date in 2018 that the rules became effective for the ATEO are generally exempt from 4960 taxes (but would still count for purposes of determining whether an employee is a covered employee).

 

  • The proposed rules also clarify that remuneration includes taxable, below market, compensation-related loans made to employees (which might arise, for example, in connection with certain split-dollar life insurance arrangements).The proposed rules clarify that nontaxable expense allowances and reimbursements (such as under an accountable plan) and other nontaxable benefits (like directors’ and officers’ liability insurance coverage) are not included in remuneration. The IRS asked for comments on whether certain taxable employee benefits (like group term life insurance over $50,000) should be included in remuneration.
  • The proposed rules create an administrative exception for payroll periods that cross over calendar years, which tracks the Form W-2 reporting rule. Specifically, regular wages are treated as paid when actually or constructively paid (not when vested). So, if a pay period ends on December 30, 2020, but salary for that period is not actually paid until January 6, 2021, then the salary is treated as paid in 2021 (and the salary is not treated as being vested in 2020). But that exception would not apply to bonuses or other irregular compensation, so if those amounts vest on December 31, 2020, they are included in 4960 for 2020, even if they are not paid until 2021.

“Covered employee” means a common law employee (including any former employee) of an ATEO if the employee is one of the five highest compensated employees of the organization for the taxable year or was a covered employee of the organization (or a predecessor) for any preceding taxable year beginning after December 31, 2016. This means that ATEOs need to identify who their common law employees are under Code Section 3401 (i.e., for purposes of withholding federal income tax from paychecks).
 

New Volunteer/Limited Services Exceptions

 One of the most-sought after changes that the IRS adopted in the proposed regulations is that certain employees of a related for-profit employer providing services to an ATEO will no longer be treated as a “covered employee,” provided that the individual’s remuneration or hours of service satisfy specific limits. Generally, the exception will apply if (1) the services provided by the individual for the ATEO are not more than 10% of the total hours of service that the individual performs for all related organizations and (2) neither the ATEO nor any other entity controlled by the ATEO pays the individual for such services. The proposed rules set out a safe harbor for individuals who do not work more than 100 hours per year for the ATEO.
 
Many stakeholders wanted this exception to avoid 4960 excise taxes on the compensation paid to executives of for-profit companies that volunteer at a related ATEO, perform minor services as unpaid officers, perform limited services, or work limited hours. For example, many for-profit executives serve as officers of a corporate foundation created by the for-profit entity and many corporations have employee-sharing arrangements with their corporate foundation. Under the statute and Notice 2019-09, those arrangements would have subjected their compensation from the corporation to 4960 excise taxes.
 
The proposed rules also set out a more complicated “non-exempt funds” exception that might rescue certain situations where the individual who primarily works for the for-profit entity provides no more than 50% of their services to the ATEO and other conditions are satisfied. The proposed rules also include details on how to count hours of service for purposes of these exceptions.

Further, the proposed rules confirm that 4960 taxes only apply to employees, not to independent contractors or members of the board of directors who are not also employees of the ATEO.

New Controlled Group/Predecessor Rules

Generally, the proposed regulations define “control” for 4960 excise taxes by using Section 512(b)(13) (i.e., the same rules for reporting related organizations on IRS Form 990). For example, the proposed rules provide that a person (or governmental entity) controls a nonstock corporation if (1) the person has the power to remove and replace more than 50% of the organization’s directors; or (2) more than 50% of the organization’s directors are “representatives” (trustees, directors, officers, employees or agents) of that person. But the proposed rules create a new exception, where an employee will not be considered a “representative” if the employee lacks authority commonly exercised by an officer, doesn’t actually act as a representative of the person, and this fact is reported on the organization’s Form 990. So, if a majority of lower-level corporate employees serve as directors or trustees of an ATEO, the for-profit entity would not be “related” to the ATEO for 4960 purposes. This alleviates concerns over “accidental control.” The IRS also clarified how “indirect control” and attribution principles work for 4960 purposes.
The proposed rules also confirm that the owner of a single member entity (such as an LLC) is the employer of the employees of that entity.
 
In addition, the proposed regulations clarify that federal government “instrumentalities” are subject to 4960, but requested comments on that issue.
 
Although the proposed rules say that a foreign organization that otherwise qualifies as an ATEO would be subject to 4960 excise taxes, the IRS has asked for public comments on whether foreign organizations that are related to an ATEO should be subject to 4960 excise taxes. The proposed regulations also clarify that a foreign organization that receives substantially all of its support from sources outside the United States would not be an ATEO.
 
Keep in mind that a “covered employee” includes any employee who was a covered employee of a predecessor ATEO. The proposed regulations outline when an entity is considered to be a predecessor ATEO, including asset acquisitions, corporate reorganizations, and chains of predecessors.
 

New Short Tax Year Rule

The proposed regulations provide guidance for determining how to handle short tax years, such as the initial or final calendar year that the ATEO is subject to 4960. For 4960 purposes, the applicable year for measuring remuneration and excess parachute payments is the calendar year that ends “with or within” the ATEO’s taxable year. For example, for an ATEO with fiscal year from July 1, 2021 to June 30, 2022, the applicable tax year is calendar year 2021 for determining who is a covered employee and what remuneration is subject to 4960 excise taxes.

Only ATEOs Owe Parachute Excise Tax

The proposed regulations revise Notice 2019-09 by providing that only ATEOs could owe an excess parachute payment excise tax, based on a separation from employment with the ATEO. Notice 2019-09 implied that an ATEO or its related organizations are liable for excess parachute payment excise tax based on the aggregate parachute payments made by the ATEO and its related organizations, including parachute payments based on separation from employment from a related organization. Now it is clear that a separation from employment from a related entity that is not itself an ATEO would not trigger 4960 tax liability. Nevertheless, the proposed rules retained the concept that payments from for-profit related organizations must still be counted when determining the “base amount” and total payments that are contingent on involuntary separation from employment for 4960 excise tax purposes.
 

Unreasonable Positions

In the proposed regulations, the IRS repeated the warning it gave in Notice 2019-09 by confirming that the following are not reasonable, good faith interpretations of 4960:

  • Related for-profit or governmental entities are not liable for their share of the 4960 excise taxes.
  • A covered employee ceases to be a covered employee after a period of time.
  • A group of ATEOs may have only five highest-compensated employees among all related ATEOs.

 

 


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Global Employer Services Newsletter – July 2020 Issue

The BDO Global Employer Services Newsletter provides a brief overview of issues affecting international assignees, predominantly, but not exclusively, from a tax and social security perspective.

This newsletter brings together individual country updates over recent months. As you will appreciate, the wealth of changes across multiple jurisdictions is significant so to provide easily digestible information we have kept it to the key developments that are likely to affect your business and international assignees.
 

In this month’s issue: